MECHANICAL DYNAMICS INC \MI\, 10-K405, 1998-03-24

MECHANICAL DYNAMICS INC \MI\
10-K405, 1998-03-24
COMPUTERS & PERIPHERAL EQUIPMENT & SOFTWARE

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<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended: DECEMBER 31, 1997, OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from ____________ to ____________

Commission file number: 0-20679

MECHANICAL DYNAMICS, INC.
(Exact name of registrant as specified in its charter)

MICHIGAN 38-2163045
(State of incorporation) (I.R.S. Employer Identification No.)

2301 COMMONWEALTH BLVD.
ANN ARBOR, MICHIGAN 48105
(734) 994-3800
(Address of principal executive offices, including zip
code, and telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:
Title of each class: NONE Name of each exchange on which registered: NONE

Securities registered pursuant to Section 12(g) of the Act:
COMMON SHARES, NO PAR VALUE
(Title of class)

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

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

The aggregate market value of the voting stock of the Registrant held
by non-affiliates of the Registrant as of March 4, 1998, computed by reference
to the Nasdaq closing price on such date, was approximately $49,855,000.

The number of outstanding shares of the Registrant's common stock, as
of March 4, 1998, was 6,150,285.

DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the 1998 Annual Meeting of
Shareholders, scheduled to be held on May 14, 1998, are incorporated by
reference into Part III.

<PAGE> 2

MECHANICAL DYNAMICS, INC.

FORM 10-K
TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
----
PART I
------
<S> <C>
Item 1. Business................................................................ 3
Item 2. Properties ............................................................. 11
Item 3. Legal Proceedings....................................................... 11
Item 4. Submission of Matters to a Vote of Security Holders..................... 11

PART II
-------
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters... 11
Item 6. Selected Consolidated Financial Data.................................... 12
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations................................................. 13
Item 8. Financial Statements and Supplementary Data............................. 19
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.................................................. 36

PART III
--------
Item 10. Directors and Executive Officers of the Registrant...................... 36
Item 11. Executive Compensation.................................................. 37
Item 12. Security Ownership of Certain Beneficial Owners and Management.......... 37
Item 13. Certain Relationships and Related Transactions.......................... 37

PART IV
-------
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K......... 38

SIGNATURES....................................................................... 39

INDEX TO EXHIBITS................................................................ 40
</TABLE>

<PAGE> 3

PART I

ITEM 1. BUSINESS

GENERAL

Since Mechanical Dynamics, Inc. ("MDI" or the "Company") was incorporated
in Michigan in 1977, the Company has developed, marketed and supported virtual
prototyping solutions. The Company's virtual prototyping software allows the
engineer or designer to design a complete product by simulating, both visually
and mathematically, a product in motion. Mechanical Dynamics' software helps
engineers and designers create optimal designs before the physical testing
process begins, improving the engineer's or designer's ability to create a
design that will meet or exceed the initial product specifications. The use of
the Company's virtual prototyping software can reduce the requirement of
building and testing numerous physical prototypes and can lead to significant
cost savings as well as critical reductions in time-to-market.

In April 1994, the Company acquired five European entities that previously
had distributed the Company's products in Europe and are now wholly-owned
subsidiaries: Mechanical Dynamics GmbH, a German corporation; Mechanical
Dynamics Sarl, a French corporation; Mechanical Dynamics International Ltd., a
United Kingdom corporation; Mechanical Dynamics Sweden AB, a Swedish
corporation; and Mechanical Dynamics Italy srl, an Italian corporation.
Mechanical Dynamics Italy srl owns a majority interest in MEC.Design srl, an
Italian corporation. Pursuant to the terms of the acquisition of the European
subsidiaries, the Company paid to the subsidiaries' shareholders stock of the
Company as well as cash.

In April 1997, the Company established a Japanese subsidiary, Mechanical
Dynamics Japan K.K. ("MDI-Japan"), through a joint venture agreement with
Information Services International-Dentsu, Ltd. ("ISI-Dentsu") of Tokyo, Japan,
the distributor of the Company's software in Japan. The Company owns 66% of
MDI-Japan, while ISI-Dentsu owns a 34% minority interest. Pursuant to the
agreement, the Company and ISI-Dentsu made combined capital contributions of
approximately $1.4 million to MDI-Japan. MDI-Japan provides consulting and
other professional services directly to customers in Japan, and supports
ISI-Dentsu in marketing the Company's software in Japan.

ADAMS(R) and the Company's logo are registered trademarks of the Company.
ADAMS/Android, ADAMS/Animation, ADAMS/Car, ADAMS/Controls, ADAMS/Driver,
ADAMS/Exchange, ADAMS/Flex, ADAMS/Linear, ADAMS/Pre, ADAMS/Rail, ADAMS/Solver,
ADAMS/Tire, ADAMS/Vehicle, ADAMS/View, AutoDOE, CAT/ADAMS, Dynamic Designer and
MECHANISM/Pro are trademarks of the Company. All rights reserved. All other
trade names and trademarks appearing in this Form 10-K are the property of
their respective holders.

<PAGE> 4

PRODUCTS

MDI develops, markets and supports virtual prototyping software packages
capable of simulating the many varied and complex component interactions and
operating environments that companies face when designing their products. The
Company's primary software line is the ADAMS Professional Series. The principal
product in this line, the ADAMS Full Simulation Package, is comprised of
ADAMS/Solver and ADAMS/View, and can be used as a self-contained software
package or with additional modules developed by the Company as well as with
third-party software. In addition, certain original equipment manufacturers
("OEM") license the Company's kinematic motion simulation software in order to
embed the Company's software in the OEM's design software packages. The U.S.
list price for the ADAMS Full Simulation Package is approximately $25,000 per
license depending upon configuration. The U.S. list prices for the Company's
additional software products typically range from $2,000 to $15,000.

ADAMS and the modular packages of ADAMS software are available on a number
of platforms, including Intel Pentium-based PCs running Microsoft Windows 95
and NT operating systems, UNIX-based workstations and servers from Silicon
Graphics, Hewlett-Packard, Sun Microsystems, IBM and Digital Equipment. ADAMS
is also available on Cray supercomputers and near supercomputers.

ADAMS PROFESSIONAL SERIES

Full Simulation Package

- ADAMS/Solver is the underlying solution "engine." ADAMS/Solver
automatically formulates and solves the equations of motion to provide complete
kinematic, static and dynamics analysis of mechanical systems.

- ADAMS/View is an interactive graphical environment for the full ADAMS
product line. ADAMS/View combines simple iconic, point-and-click operation with
advanced model-building, simulation, animation and xy plotting capabilities.

Modeling Options

- ADAMS/Vehicle is used for the design and analysis of automobile and
truck suspensions or for simulating full vehicle dynamics. A user chooses from
a wide variety of suspension templates to quickly and easily build vehicle
models.

- ADAMS/Tire is a comprehensive set of tools for simulating the complex
force interactions between rubber tires and driving surfaces. This can be
important input for understanding vehicle behavior under a variety of
conditions.

- ADAMS/Driver allows the user to add the element of human driver response
to vehicle simulations. ADAMS/Driver can simulate the actions and reactions of
a vehicle's operator under a variety of driving conditions.

- ADAMS/Android allows a user to model and simulate human bodies in
motion. ADAMS/Android is used to study the complex dynamic interaction between
humans and mechanical systems, without risking the comfort and safety of live
subjects.

Solution and Integration Options

- ADAMS/Flex automates the exchange of data between ADAMS and finite
element analysis ("FEA") software, including ANSYS and MSC/NASTRAN. This
two-way interface provides for accurate loading conditions for FEA and a more
complete understanding of flexible effects on mechanical systems.

- ADAMS/Exchange provides an industry-standard, two-way interface for
exchanging model geometry between ADAMS and many other CAD/CAM/CAE packages.
This saves time in data transfer, while enhancing the accuracy and realism of
mechanical system simulations.

<PAGE> 5

- ADAMS/Linear simplifies the non-linear equations of motion calculated by
ADAMS. Having such data in linear form can significantly enhance the ability to
study the stability and vibratory behavior of mechanical system models.
ADAMS/Linear can also provide an easy link to popular control system design
packages such as MATRIXx and MATLAB.

- ADAMS/Controls simplifies the integration of non-linear ADAMS mechanical
models with control and hydraulic systems developed in leading control system
design packages including MATLAB, MATRIXx and EASY5. The product allows the
user to test how control systems will affect their mechanical system, and
visualize the effects of both controls and mechanics in a virtual system test
environment.

Visualization Option

- ADAMS/Animation allows a user to see the complete system in motion -- in
real time, fully shaded and rendered. ADAMS/Animation checks and reports
potential collision of parts and components and shows important measurements on
screen. ADAMS/Animation also allows for multiple light sources, texture
mapping, detailed color specifications and multiple perspectives. These enhance
the understanding of the design and can result in more successful design
reviews.

Industry-specific packages

- ADAMS/Car was developed by the Company in collaboration with AB Volvo,
Audi AG, BMW, Nissan Motor Co., Renault and Rover Group P.L.C. ADAMS/Car is a
special version of ADAMS designed specifically for advanced vehicle simulation.
Embedded within the software are the specialized design and analytical
expertise of automotive industry leaders. A custom menu-driven user interface
highlights capabilities familiar to vehicle designers so customers can use
ADAMS/Car with little formal training.

- ADAMS/Pre rights were acquired by the Company in conjunction with its
acquisition of StatDesign, Inc., in October 1997. ADAMS/Pre is a pre-processing
environment for ADAMS designed specifically for the automotive environment.

- AutoDOE was purchased by the Company in conjunction with its acquisition
of StatDesign, Inc., in October 1997. AutoDOE is a software package used for
creating statistically defined design of experiments programs. Design of
experiments methods allow users to run a battery of simulations on a mechanical
system design to determine the effects of multiple design or manufacturing
variations on system performance and behavior. With design of experiments,
product designs can be optimized more quickly than through the traditional
process of testing one factor at a time.

- ADAMS/Rail was developed by the Company in collaboration with Dutch Rail
and provides virtual prototyping capabilities tailored to the needs of the
worldwide railcar manufacturing industry. The software combines specialized
railcar design and analytical know-how with custom menus and functions
developed specifically for railcar engineers.

ADAMS CAD-EMBEDDED PRODUCTS

CAD-Embedded Products are products specifically designed for the CAD/CAM
environments. Assemblies created within the Company's partners' software
environments are converted into realistic, fully three-dimensional mechanical
system models. These software environments then verify and evaluate motion
paths, locate lock-up positions, detect interferences, establish work-space
envelopes and calculate joint reaction forces.

- OEM Products are kinematic motion simulation products that are embedded
in OEMs' design software packages. The Company has entered into license
agreements or arrangements with several OEMs, including Structural Dynamics
Research Corporation, EDS/Unigraphics, Bentley Systems, Tecnomatix Technologies
Ltd., Intergraph and Applicon, under which the OEMs are licensed to embed the
Company's products in the OEMs' software packages. These products provide
limited virtual prototyping capabilities, and can be upgraded by licensing
ADAMS/Solver directly from the Company.

<PAGE> 6

- MECHANISM/Pro is a program specifically designed for Parametric
Technology Corp.'s ("PTC") Pro/ENGINEER environment. MECHANISM/Pro converts
assemblies created within PTC's Pro/ASSEMBLY software into realistic, fully
three-dimensional mechanical system models. MECHANISM/Pro can verify and
evaluate motion paths, locate lock-up positions, detect interferences,
establish work-space envelopes and calculate joint reaction forces.

- CAT/ADAMS was developed by the Company in collaboration with a
consortium of major automotive manufacturers, and was designed to facilitate
the exchange of data between ADAMS and the widely-used CATIA computer-aided
design, manufacturing, and engineering (CAD/CAM/CAE) package from Dassault
Systemes.

- Dynamic Designer was purchased by the Company in conjunction with its
acquisition of DTI, in January 1998. Dynamic Designer is a mechanical design
simulation software product embedded in the AutoCAD and Mechanical Desktop
product lines from Autodesk, Inc. Similar embedded ADAMS simulation
capabilities for SolidWorks 97 from SolidWorks Corp. have been developed by
the Company.

SERVICES

The Company provides consulting, training and technical support services
to customers in connection with a wide range of product design and engineering
projects. MDI's primary objectives with regard to its services include: (1)
providing total solutions to its customers' problems; (2) leveraging software
sales; (3) enhancing customer loyalty and repeat and renewal business; (4)
growing the services business of the Company profitably; (5) aggressively
exploring and penetrating new markets; and (6) obtaining customer feedback on
its products.

The Company strives to identify key companies within various industries
with whom it seeks to develop close working relationships. The Company seeks to
foster technological partnerships with these companies by providing a
comprehensive service package, which addresses the particular virtual
prototyping needs of the companies. By doing this, MDI provides a total
solution for the customer, which can lead to increased acceptance of virtual
prototyping in the applicable industry.

In addition to its consulting services, the Company also provides training
to enable its customers to more easily integrate virtual prototyping technology
into their design and quality control processes.

The Company's services staff provides these services on either a time and
materials or a fixed fee basis depending on the project and the requirements of
the customer. Contract fees range from a few thousand dollars to several
hundred thousand dollars depending upon the scope of the project, and contract
durations range from a few weeks to several years.

A critical component of MDI's strategy is to provide a wide range of
customer support services. These services include hotline support and on-site
support and training. Product support is provided pursuant to renewable annual
maintenance contracts. Customers who purchase maintenance agreements receive
product enhancement releases and hotline support at no additional charge.
On-site support and training are priced separately. Approximately 15.9%, 16.2%,
and 16.3% of the Company's total revenue was realized from maintenance
contracts in 1997, 1996, and 1995, respectively.

CUSTOMERS

The Company's customers include companies in a wide variety of industries.
Historically, the Company's largest customers have been automobile
manufacturers and automotive suppliers. During 1997, 1996, and 1995,
automotive-related customers accounted for approximately 50.5%, 48.1%, and
50.7% of the Company's total revenue, respectively. Ford Motor Company
accounted for approximately 10.6%, 11.8%, and 13.2% of the Company's total
revenue in 1997, 1996, and 1995, respectively. No other customer accounted for
greater than 10% of the Company's total revenue in such periods.

<PAGE> 7

SALES AND MARKETING

The Company markets its products through direct sales in North America,
Europe and to a lesser extent in Asia, approximately 15 value-added resellers
throughout North America, a group of international distributors in over 20
countries and through reselling alliances with certain integrated mechanical
CAD/CAM/CAE software vendors. The Company conducts sales activities from its
headquarters in Ann Arbor, Michigan, domestic sales offices in Atlanta, GA;
Austin, TX; Chicago, IL; Cleveland, OH; Los Angeles, CA; Londonderry, NH;
Phoenix, AZ; and San Francisco, CA, as well as its European subsidiaries'
offices in England, France, Germany (three offices), Italy (two offices),
Sweden (2 offices) and Japan, and its foreign branch offices in China and
India. The Company employs engineers and technically proficient salespersons
capable of serving the technology needs of current and prospective customers'
engineering, design and manufacturing staffs.

The Company has formed strategic alliances with several leading hardware
vendors, including Hewlett-Packard, Silicon Graphics and Sun Microsystems.
Through these strategic alliances, the Company and the vendor participate in
various projects which enhance both the visibility and acceptance of the
Company's products, such as joint presentations to customers and the trade
press, joint advertising and promotion, conference presentations and displays.

The Company also has alliances with vendors of complementary
computer-aided engineering technology, such as ANSYS, Inc., Integrated Systems,
Inc., The MacNeal-Schwendler Corporation, and The Mathworks, Inc. These
relationships entail collaborative development to support interfaces between
the software products of the Company and each partner, as well as cooperative
marketing and selling activity. By working with these vendors, the Company
seeks to satisfy the needs of its customers across a wide range of
computer-aided engineering applications. The Company and its partners jointly
participate in promotional activities, trade shows, user conferences, customer
presentations and customer proposals.

The Company has also formed relationships with several CAD/CAM companies,
including Structural Dynamics Research Corporation, Electronic Data Systems
Corporation (Unigraphics Division), Parametric Technology Corp., Dassault
Systemes, Bentley Systems, Inc., Tecnomatix Technologies Ltd., SolidWorks
Corp., Intergraph Corporation and Applicon, Inc. Through these alliances, the
Company collaborates with its partners to develop and support embedded, add-on
software modules for each CAD/CAM environment. These embedded modules enable
CAD/CAM users to model and simulate mechanical systems and interface with the
Company's full ADAMS product line. The Company believes that strategic
alliances are important to its long-term success and intends to continue to
pursue such alliances in the future.

International revenue (i.e., revenue from sales outside of North America)
accounted for approximately 65.2%, 67.0%, and 66.2% of the Company's total
revenue in 1997, 1996, and 1995, respectively. In Asia, the Company primarily
markets its products and services through contractual relationships with
distributors in Japan, Korea, India, China, Taiwan and Singapore. The Company's
largest distributor, ISI-Dentsu, is located in Japan and accounted for
approximately 15.3%, 16.5%, and 19.3% of the Company's total revenue in 1997,
1996, and 1995, respectively. The Company's consolidated operations to date
have not been materially adversely affected by the recent uncertainty in the
Asian markets. During 1997, the Company experienced a decrease in revenue from
Korea, however, this decrease was more than offset by revenue growth in Japan.
If the economies in Asia continue to deteriorate in 1998, the Company's overall
Asian revenue could be adversely impacted, which could have a material adverse
effect on the Company's consolidated results of operations.

The Company generally prices its software products and services in local
currencies in Europe and Japan. The strengthening of the dollar in 1997,
relative to the European and Japanese currencies, negatively affected 1997
international revenue by approximately $1.2 million. Since most of the
Company's international operating expenses were incurred in foreign currencies,
the net impact of exchange rate fluctuations on income from operations was
considerably less than the impact on revenue. If the dollar continues to
strengthen in 1998 relative to the European and Japanese currencies, the
Company's international revenue will be negatively impacted, which could have a
material adverse effect on the Company's consolidated results of operations.

<PAGE> 8

The Company expects that international sales will continue to account for
a significant portion of its total revenue in future periods. The Company
intends to continue to expand its operations outside of the United States,
which will require significant management attention and financial resources.
International operations are subject to inherent risks, including unexpected
changes in regulatory requirements, tariffs and taxes, difficulties in staffing
and managing foreign operations, longer payment cycles, greater difficulty in
accounts receivable collection, compliance with applicable export licensing
requirements and other trade barriers and political and economic instability.
Moreover, gains and losses on the conversion to U.S. dollars of receivables and
payables arising from international operations may contribute to fluctuations
in the Company's results of operations. The Company does not currently engage
in hedging transactions. In addition, if for any reason exchange or price
controls or other restrictions on foreign currencies were imposed, the
Company's business, financial condition and results of operations could be
materially adversely affected. Currency exchange fluctuations in countries in
which the Company licenses its products in U.S. dollars could have a material
adverse effect on the Company's business, financial condition and results of
operations by resulting in pricing that is not competitive with products priced
in local currencies. In addition, the laws of certain countries do not protect
the Company's products and intellectual property rights to the same extent as
do the laws of the United States. There can be no assurance that any of these
factors will not have a material adverse effect on the Company's future
international operations and sales and, consequently, on the Company's
business, financial condition and results of operations.

RESEARCH AND DEVELOPMENT

The Company's success depends in large part upon its ability to enhance
current products and to develop and introduce new products on a timely and
cost-effective basis. The Company's current software development efforts are
focused on developing additional products and services to complement its core
competencies of developing, marketing and supporting mechanical system modeling
and simulation software packages. The Company's product development efforts
also emphasize enhancement, integration and extensibility of its virtual
prototyping software.

The Company has historically released one new version of its software to
its customers per year and intends to continue such releases. The Company also
provides periodic releases to its OEM software partners. As part of this
release process, the Company continually communicates with its customers and
partners and solicits comments for improved ease of use and general customer
satisfaction.

The Company's software developers work as a team with the Company's sales,
marketing and consulting personnel to achieve a robust, high-quality product
line.

The Company also sponsors and maintains a network of academic and
commercial research affiliates to promote recognition and commercialization of
applicable emerging technology. Some of the technology areas which have
recently been explored include: kinematics, elastodynamics, numerical methods,
design sensitivity, optimization, symbolic computing, advance graphics and
visualization, user interfaces, tire dynamics, biomechanics, ergonomics,
controls design and hydraulics.

As of December 31, 1997, the Company's research and development group
consisted of 56 full-time employees. During 1997, 1996, and 1995, the Company's
research and development expenses were approximately $4.8 million, $3.7
million, and $2.9 million, respectively. The Company anticipates that it will
commit substantial resources to research and development in the future.

The virtual prototyping industry is characterized by rapid technological
changes, frequent new product introductions and evolving industry standards
that may render existing products and services obsolete. Consequently, to
maintain its competitive position, the Company must enhance its existing
software products and develop and introduce new products on a timely basis. In
addition, in order to maintain and broaden the market for its software
products, the Company must support a variety of computer systems and graphics
devices. There can be no assurance that the Company will not experience
difficulties that could delay or prevent the successful development,
introduction and marketing of these products, or that such new products and
product enhancements will adequately meet the requirements of the marketplace
and achieve market acceptance. If the Company is unable to develop and
introduce products in a timely manner in response to changing market conditions
or customer requirements, the Company's business, financial condition and
results of operations would be materially adversely affected.

<PAGE> 9

BACKLOG

The Company typically ships its products within 30 days after acceptance
of a customer purchase order and execution of a software license agreement.
Accordingly, the Company does not believe that its backlog at any particular
point in time is indicative of future revenue levels.

COMPETITION

The markets for the Company's products and services are highly competitive
and subject to rapid change. The Company believes the principal competitive
factors in this market are product quality, ease of use, quality of support,
performance and price, functionality and features, ease of integration with
customers' design processes, strategic alliances and vendor and product
reputation. In general, the Company's current competition comes from three
sources: other virtual prototyping software vendors, including Parametric
Technology Corp., the internal software development groups of its current or
potential customers, and the traditional method of testing hardware prototypes,
whether performed internally or externally, by the Company's current or
potential customers. Many companies have their own software development groups
that historically have developed their own software design tools. This has
required the Company and other vendors to compete against these internal groups
to sell their products into these companies. A number of the Company's
competitors have longer operating histories, greater financial, technical,
sales, marketing and other resources, greater name recognition, more extensive
distribution and sales networks and a larger, more established customer base.
Among the Company's current and potential competitors are also a number of
large hardware and software companies that may develop or acquire products that
compete with the Company's products. Current and potential competitors have
established or may establish cooperative relationships among themselves or with
third parties to increase the ability of their products to address the needs of
the Company's prospective customers. Accordingly, it is possible that new
competitors or alliances among competitors may emerge and rapidly acquire
significant market share. Increased competition is likely to result in price
reductions, reduced operating margins and loss of market share, any of which
could materially adversely affect the Company's business, results of operations
and financial condition. There can be no assurance that the Company will be
able to compete successfully in the future or that competitive pressures will
not have a material adverse effect the Company's business, financial condition
and results of operations.

PROPRIETARY RIGHTS

The Company's success depends in large part upon its proprietary software
technology. The Company currently relies on trade secret, copyright and
trademark laws, and license agreements with all of its customers to protect its
proprietary rights in its software products. The Company also ships its
software with either an encoded password scheme or a security device. The
Company's software copies are locked to a specific central processing unit and
contain codes that will prohibit the user from running the software after a
certain date. The Company generally enters into proprietary information and
confidentiality agreements with its employees and distributors, and limits
access to and distribution of its software, documentation and other proprietary
information. The Company generally does not license or release the source code
for its proprietary software to third parties. Despite these precautions, there
can be no assurance that a third party will not copy or otherwise obtain and
use the Company's products or technology without authorization, or develop
similar or superior technology independently. The Company distributes its
Dynamic Designer software products and demonstration copies of its other
products in North America, Europe and Asia pursuant to "shrink-wrap" licenses.
There can be no assurance that such licenses are enforceable. In addition,
effective copyright and trade secret protection may be unavailable or limited
in certain foreign countries. Litigation may be necessary in the future to
enforce the Company's intellectual property rights, to protect the Company's
trade secrets, to determine the validity and scope of the proprietary rights of
others or to defend against claims of infringement or invalidity. Such
litigation could result in substantial costs and diversion of resources and
could have a material adverse effect on the Company's business, financial
condition and results of operations. Although the Company believes that its
products do not infringe on the proprietary rights of third parties, and
although the Company has received no communications from third parties alleging
the infringement of the proprietary rights of such parties, there can be no
assurance that infringement claims will not be asserted against the Company in
the future or that any such claims will not require the Company to enter into
costly litigation. Irrespective of the validity or the successful assertion of
such claims, any such litigation could result in substantial costs and a
significant

<PAGE> 10

diversion of management's attention and resources, and these results as well as
any adverse judgment that might be rendered could have a material adverse
effect on the Company's business, financial condition and results of
operations. In addition, if any claims or actions are asserted against the
Company, the Company may choose or be required to obtain a license under a
third party's intellectual property rights. There can be no assurance that
under such circumstances a license would be available upon reasonable terms or
at all.

Certain technology used by the Company's products is licensed from third
parties, generally on a nonexclusive basis. The Company believes that there are
alternative sources for each of the material components of technology licensed
by the Company from third parties. However, the termination of any of such
licenses, the failure of the third party licensors to adequately maintain or
update their products, or the substantial increase in the license fee
associated with such licenses, could result in delay in the Company's ability
to deliver certain of its products while it seeks to implement technology
offered by alternative sources and may adversely affect the Company's business,
financial condition and results of operations. Any required replacement
licenses could prove costly. Also, any such delay, to the extent it becomes
extended or occurs at or near the end of a quarter, could result in a material
adverse effect on the Company's quarterly results of operations. While it may
be necessary or desirable in the future to obtain other licenses relating to
one or more of the Company's products or relating to current or future
technologies, there can be no assurance that the Company will be able to do so
on reasonable terms or at all.

EMPLOYEES

As of December 31, 1997, the Company had 234 employees, consisting of 78
in engineering services, 75 in sales and marketing, 56 in research and
development and 25 in general and administrative capacities. Of these, 149 are
located at the Company's headquarters in Ann Arbor, Michigan, 20 are located at
the Company's domestic offices in Arizona, Georgia, Texas, Illinois, Ohio,
California, Washington, Wisconsin and New Hampshire, 63 are located at the
Company's European and Asian subsidiaries and 2 are located at the Company's
foreign branch offices in China and India. None of the Company's employees is
represented by a labor union or is subject to a collective bargaining
agreement. The Company believes that its relations with its employees are good.

The Company's success depends in large part upon the continued service of
its key technical and senior management personnel. The Company's success also
depends on its continuing ability to attract and retain highly qualified
technical, sales and marketing, and managerial personnel. Competition for such
personnel is intense, and there can be no assurance that the Company can retain
its key managerial and technical employees or that it can attract, assimilate
or retain other highly qualified personnel in the future. If the Company is
unable to hire the necessary technical personnel, the development of new
products could be impaired. The Company's inability to attract, assimilate or
retain personnel in the future on a timely basis could have a material adverse
effect on the Company's business, financial condition and results of
operations.

<PAGE> 11

ITEM 2. PROPERTIES

The Company occupies approximately 39,000 square feet of space at its
headquarters in Ann Arbor, Michigan. Approximately 3,200 square feet will
expire in 1998 with the remaining 35,800 square feet expiring in 2000 (subject
to the Company's right to extend the lease for one successive term of five
years). The Company also leases sales offices in Michigan, Texas, Illinois,
California, New Hampshire, France, Sweden, England, Germany, Italy, Japan,
China and India. The Company believes that its existing facilities are adequate
for its current needs and that suitable additional space will be available as
needed.

ITEM 3. LEGAL PROCEEDINGS

The Company is involved in various ordinary or routine litigation
incidental to its business, none of which, in the opinion of management, is
deemed to be material.

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

No matters were submitted to a vote of shareholders during the last
quarter of the year ended December 31, 1997.

PART II

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

The Company's common stock is listed on the Nasdaq National Market under
the trading symbol "MDII." The range of high and low sale prices for the
Company's common stock on that market for each of the quarters since the
Company's initial public offering in May 1996 are as follows:

<TABLE>
<CAPTION>
MARKET PRICES
---------------------
HIGH LOW
- ----------------------------------------------------------------
<S> <C> <C>
Year ended December 31, 1997:
Fourth quarter........................... $10.00 $ 6.50
Third quarter............................ 8.63 5.75
Second quarter........................... 10.38 5.81
First quarter............................ 13.75 6.25
Year ended December 31, 1996:
Fourth quarter........................... $18.13 $13.50
Third quarter............................ 18.13 11.50
Second quarter (beginning May 14, 1996).. 20.88 14.25
</TABLE>

As of December 31, 1997, there were 188 shareholders of record of the
Company's common stock. This may not be an accurate indication of the total
shareholders of the Company as of December 31, 1997, since many nominees hold
the Company's shares in street name for the beneficial owners.

The Company has never declared or paid cash dividends on its capital stock
and anticipates that, for the foreseeable future, it will continue to retain
any earnings for use in the operation of its business.

In October 1997, the Company acquired 100% of the outstanding capital
stock of StatDesign, Inc. In connection with this purchase, the Company issued
170,227 shares of the Company's common stock, none of which have been
registered under the Securities Act of 1933. The consideration for this
transaction was a cash payment of approximately $1.4 million and the issuance
of 170,227 shares of the Company's common stock valued for this purpose at
approximately $868,000. These shares were issued in reliance upon the
exemption from registration contained in Section 4(2) of the Securities Act of
1933.

<PAGE> 12

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

The consolidated statement of income data for the years ended December 31,
1997, 1996, 1995, 1994 and 1993 and the consolidated balance sheet data as of
December 31, 1997, 1996, 1995 and 1994 presented below are derived from the
Company's Consolidated Financial Statements audited by Arthur Andersen LLP. The
consolidated balance sheet data as of December 31, 1993 presented below has
been derived from unaudited financial statements that, in management's opinion,
includes all necessary adjustments (consisting only of normal recurring
adjustments) to present fairly the financial condition and results of
operations for such periods and dates.

<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------------------------
In thousands, except per share data 1997 1996 1995 1994 1993
- ---------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT OF INCOME DATA:
Revenue..................................... $30,191 $25,383 $21,256 $16,267 $14,874
Operating income............................ 965 (1) 2,503 1,666 635 1,804
Net income.................................. 744 2,071 1,381 450 1,354
Accretion of value of warrants.............. -- -- 234 664 --
Net income (loss) available to common
shareholders.............................. 744 2,071 1,147 (214) 1,354
Pro forma diluted net income (loss) per
common share.............................. 0.13 0.41 0.30 (0.06) 0.38

Excluding acquisition and related costs (1):
Operating income.......................... 2,655 (1) 2,503 1,666 635 1,804
Net income (loss) available to common
shareholders............................ 2,434 2,071 1,147 (214) 1,354
Pro forma diluted net income (loss) per
common share............................ 0.41 0.41 0.30 (0.06) 0.38

<CAPTION>
AS OF DECEMBER 31,
---------------------------------------------------
In thousands 1997 1996 1995 1994 1993
- ---------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents................... $20,261 $20,570 (2) $ 1,141 $ 817 $ 60
Total assets................................ 34,147 29,812 9,338 7,334 4,626
Long-term debt, less current portion........ -- -- -- 79 67
Redeemable common stock..................... -- 167 859 1,191 --
Shareholders' equity (deficit).............. 23,970 22,185 (2) 1,334 (77) (236)
</TABLE>

NOTES:

(1) For the year ended December 31, 1997, the Company recorded a $1.7 million
charge to operations for the write-off of purchased in-process research
and development related to the acquisition of StatDesign, Inc.

(2) For the year ended December 31, 1996, the Company completed an initial
public offering of its stock, which resulted in the issuance of 1,500,000
shares at $11.00 per share. An additional 354,750 shares were sold by the
Company at $11.00 per share to cover over-allotments. The offering,
including the over-allotments, raised $17.8 million in net proceeds.

<PAGE> 13
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following discussion provides an analysis of the Company's financial
condition and results of operations, and should be read in conjunction with
the Company's consolidated financial statements and the notes thereto included
in Item 8 of this Form 10-K.

OVERVIEW

The Company develops, markets and supports virtual prototyping solutions.
The Company's virtual prototyping software allows the engineer or designer to
design a complete product by simulating, both visually and mathematically, a
product in motion. The Company's principal software product, ADAMS Full
Simulation Package, is used by customers to simulate mechanical systems. The
Company's revenue has in the past been, and is expected in the future to be,
derived primarily from its ADAMS Full Simulation Package and related software
products and services.

FORWARD-LOOKING INFORMATION IS SUBJECT TO RISK AND UNCERTAINTY

Except for the historical information contained in this report, the
matters herein contain "forward-looking" statements (as defined in the Private
Securities Litigation Reform Act of 1995) that involve risk and uncertainty.
These forward-looking statements include, but are not limited to, revenue
levels, including the level of international revenue, certain costs and
operating expense levels, the level of other income, the Company's liquidity
and capital needs and various business environment and trend information.
Actual future results and trends may differ materially depending on a variety of
factors, including the volume and timing of orders received during the quarter,
the mix of and changes in distribution channels through which the Company's
products are sold, the timing and acceptance of new products and product
enhancements by the Company or its competitors, changes in pricing, the level
of the Company's sales of third party products, purchasing patterns of
distributors and customers, competitive conditions in the industry, business
cycles affecting the markets in which the Company's products are sold,
extraordinary events, such as litigation or acquisitions, including related
charges, and economic conditions generally or in various geographic areas. All
of the foregoing factors are difficult to forecast. The future operating
results of the Company may fluctuate as a result of these and other risk
factors detailed from time-to-time in the Company's Securities and Exchange
Commission reports and included in Item 1 of this Form 10-K entitled
"Business."

Due to all of the foregoing factors, the Company believes that
period-to-period comparisons of its results of operations are not necessarily
meaningful and should not be relied upon as an indication of future
performance. It is likely that, in some future quarters, the Company's
operating results will be below the expectations of stock market analysts and
investors. In such an event, the price of the Company's Common Stock would
likely be materially adversely affected.

RESULTS OF OPERATIONS

REVENUE

<TABLE>
<CAPTION>
Dollars in thousands 1997 % CHANGE 1996 % CHANGE 1995
- -------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Software licenses..... $17,258 18.3% $14,590 18.3% $12,338
% of total revenue.. 57.2% 57.5% 58.0%
Services.............. $12,933 19.8% $10,793 21.0% $ 8,918
% of total revenue.. 42.8% 42.5% 42.0%
Total revenue......... $30,191 18.9% $25,383 19.4% $21,256
</TABLE>

The Company's total revenue increased 18.9% to $30.2 million in 1997 from
$25.4 million in 1996. During 1996, total revenue increased 19.4% from $21.3
million in 1995. The growth in revenue during 1997 and 1996 resulted from
increased sales of the Company's ADAMS Full Simulation Package, as well as
other related software products and services. During both years, the Company
achieved revenue growth in each of its major sales

<PAGE> 14

geographies, including North America, Europe and Asia. A summary of the
Company's revenue by geographic area is presented in Note 8 of Notes to
Consolidated Financial Statements.

Revenue from international customers accounted for approximately 65.2%,
67.0% and 66.2% of the Company's total revenue in 1997, 1996 and 1995,
respectively. The decrease in international revenue as a percent of total
revenue during 1997, as compared to 1996, was due in part to the strengthening
of the dollar during 1997 as described below, as well as increased sales of the
Company's software products and services in North America. The Company's
consolidated operations to date have not been materially adversely affected by
the recent uncertainty in the Asian markets. During 1997, the Company
experienced a decrease in revenue from Korea, however, this decrease was more
than offset by revenue growth in Japan. If the economies in Asia continue to
deteriorate in 1998, the Company's overall Asian revenue could be adversely
impacted, which could have a material adverse effect on the Company's
consolidated results of operations. The Company expects that international
revenue will continue to account for a significant portion of its total revenue
in future periods.

Outside of North America and Europe, the Company relies primarily on
distributors and sales representatives for the licensing and support of its
products. Distributors and sales representatives accounted for approximately
27.8%, 27.6% and 25.9% of the Company's total revenue in 1997, 1996 and 1995,
respectively. The Company's Japanese distributor, Information Services
International - Dentsu, Ltd. ("ISI-Dentsu"), accounted for approximately 15.3%,
16.5% and 19.3% of the Company's total revenue in 1997, 1996 and 1995,
respectively.

Revenue from automotive-related customers accounted for approximately
50.5%, 48.1% and 50.7% of the Company's total revenue in 1997, 1996 and 1995,
respectively. Sales to Ford Motor Company accounted for approximately 10.6%,
11.8% and 13.2% of the Company's total revenue in 1997, 1996 and 1995,
respectively. No other customer accounted for greater than 10% of the Company's
total revenue in such periods.

Software licenses revenue consists primarily of license fees for the
Company's software products and, to a lesser extent, license fees from other
companies' software products licensed through the Company's European
subsidiaries. Software licenses revenue grew 18.3% over 1996 to approximately
$17.3 million in 1997. The increase resulted from a higher volume of software
licenses sold worldwide. In 1996, software licenses revenue grew 18.3% over
1995 to approximately $14.6 million.

Services revenue consists primarily of revenue from software maintenance
agreements and professional services, including consulting, training and funded
research and development. Total services revenue grew 19.8% over 1996 to
approximately $12.9 million in 1997. The overall increase in services revenue
reflects the Company's continued emphasis on providing total solutions to its
customers. Software maintenance revenue grew 16.9% in 1997 to $4.8 million,
while professional services revenue grew 23.3% in 1997 to $7.9 million. The
increase in professional services revenue in 1997 was partially offset by a
$400,000 decline in funded research and development revenue. The majority of
this decline can be attributed to funded research and development revenue
generated during 1996 from the customization of the Company's ADAMS/Car
software product for a single customer in Japan. Total services revenue grew
21.0% over 1995 to approximately $10.8 million in 1996. Both the software
maintenance and the professional service components of services revenue
experienced solid growth in 1996. Software maintenance revenue totaled $4.1
million in 1996, an 18.6% increase over 1995. Professional services revenue
totaled $6.4 million in 1996, a 22.4% increase over 1995.

<PAGE> 15

COST OF REVENUE

<TABLE>
<CAPTION>
Dollars in thousands 1997 % CHANGE 1996 % CHANGE 1995
- ----------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Cost of software licenses......... $ 791 30.5% $ 606 (16.8%) $ 728
% of software licenses revenue.. 4.6% 4.2% 5.9%

Cost of services.................. $7,066 14.3% $6,183 19.0% $5,194
% of services revenue........... 54.6% 57.3% 58.2%
</TABLE>

Cost of software licenses includes software royalty fees, media costs,
payroll and other costs attributable to software documentation and
distribution, and an allocation of depreciation, utilities and other overhead
expenses incurred by the Company. Cost of software licenses revenue increased
30.5% from 1996 to approximately $791,000 in 1997. The $185,000 absolute dollar
increase was primarily due to additional royalties paid to third parties whose
products are embedded in the Company's ADAMS software. In 1996, cost of
software licenses revenue decreased 16.8% from 1995 to approximately $606,000.
The decrease was primarily due to lower royalties paid to third parties whose
products were licensed through the Company's European subsidiaries.

Cost of services includes payroll and overhead expenses attributable to
hotline support, consulting, training and funded research and development.
Cost of services revenue grew 14.3% over 1996 to approximately $7.1 million in
1997. In 1996, cost of services revenue grew 19.0% over 1995 to approximately
$6.2 million. The increases resulted from the hiring of additional employees to
support the growth in services provided to the Company's customers during 1997
and 1996.

OPERATING EXPENSES

<TABLE>
<CAPTION>
Dollars in thousands 1997 % CHANGE 1996 % CHANGE 1995
- -----------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Sales and marketing......... $11,705 21.0% $9,672 19.1% $8,118
% of total revenue........ 38.8% 38.1% 38.2%

Research and development.... $ 4,756 29.6% $3,669 24.8% $2,940
% of total revenue........ 15.8% 14.5% 13.8%

General and administrative.. $ 3,218 17.0% $2,750 5.4% $2,610
% of total revenue........ 10.7% 10.8% 12.3%

Purchased in-process
research and development.. $ 1,690 -- $ -- -- $ --
% of total revenue........ 5.6% -- --
</TABLE>

Sales and marketing expenses include costs associated with the Company's
sales channels, such as personnel, commissions, sales office costs, travel,
promotional events, sales order processing, including license administration
and order fulfillment, and advertising and public relations programs. Sales and
marketing expenses also include an allocation of overhead expenses incurred by
the Company. The absolute dollar increases in sales and marketing expenses in
1997 and 1996 resulted from the Company's continued expansion of its worldwide
sales and marketing organization, as well as the increase in commissions paid
on the higher level of software licenses revenue. During 1997, the number of
employees in sales and marketing increased from 49 to 75. The Company expects
to continue to expand its sales organization in the future to meet the growing
demand for its products and services.

Research and development expenses include all payroll costs attributable
to research and development activities. Research and development expenses also
include an allocation of overhead expenses incurred by the Company. The
absolute dollar increases in research and development expenses in 1997 and 1996
primarily resulted from an increase in personnel and related costs in support
of expanded product development efforts. Funded research and development
expenses, which are not included in research and development expenses but are
included in cost of services revenue, were 2.7%, 3.6% and 3.2%, of total
revenue in 1997, 1996 and 1995, respectively. The majority of the revenue
received and expenses incurred for funded research and development was directly
related to projects

<PAGE> 16

associated with the ongoing development of the Company's ADAMS/Car product. The
Company intends to continue to invest significant resources in research and
development in the future.

General and administrative expenses include the cost of salaries, employee
benefits and other payroll costs associated with the Company's finance,
accounting, human resources, information systems and executive management
functions. General and administrative expenses also include an allocation of
overhead expenses incurred by the Company. General and administrative expenses
grew 17.0% over 1996 to approximately $3.2 million in 1997, in support of the
Company's growing operations worldwide. General and administrative expenses
grew 5.4% over 1995 to approximately $2.8 million in 1996. The Company expects
general and administrative expenses to increase in absolute dollars in the
future. However, these expenses may vary as a percentage of total revenue from
period to period.

Purchased in-process research and development includes a one-time charge
of approximately $1.7 million associated with the write-off of in-process
research and development that had not reached technological feasibility. The
write-off was recorded in connection with the acquisition of StatDesign, Inc.
on October 31, 1997. The accounting for the acquisition of StatDesign, Inc. is
summarized in Note 2 of Notes to Consolidated Financial Statements.

OTHER INCOME, NET

<TABLE>
<CAPTION>
Dollars in thousands 1997 % CHANGE 1996 % CHANGE 1995
- ---------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Other income, net ......... $791 47.6% $536 >100% $9
% of total revenue....... 2.6% 2.1% --
</TABLE>

Other income, net consists of net interest income (expense), foreign
currency transaction gain (loss) and gain (loss) on the disposal of property
and equipment. Net interest income was $953,000, $556,000, and $12,000 in 1997,
1996 and 1995, respectively. Interest income increased significantly in 1997
and 1996, primarily as a result of interest earned on the $17.8 million in net
proceeds raised from the Company's initial public offering in May 1996.
Foreign currency transaction loss amounted to $(129,000), $(31,000) and
$(31,000) in 1997, 1996 and 1995, respectively. The Company does not currently
engage in any hedging activities to protect itself against foreign currency
transaction gains and losses. Gain (loss) on the disposal of property and
equipment was $(33,000), $11,000 and $28,000 in 1997, 1996 and 1995,
respectively.

PROVISION FOR INCOME TAXES

The Company's effective income tax rates were 57.9%, 31.9% and 17.6% for
1997, 1996 and 1995, respectively. The differences between the consolidated tax
provision and the income tax provision calculated at the United States Federal
statutory rate are summarized in Note 4 of Notes to Consolidated Financial
Statements. In 1997, the difference between the effective and statutory federal
rate was primarily due to the non-deductibility of the expense associated with
purchased in-process research and development. This unfavorable difference was
partially offset by the benefit of the Company's foreign sales corporation, and
the benefit of tax-exempt interest income. In 1996, the difference between the
effective and statutory federal rate was primarily due to the recognition of
the value of certain tax credits and deferred assets, and, to a lesser extent,
the benefit of tax-exempt interest income.

MINORITY INTEREST IN NET INCOME (LOSS) OF SUBSIDIARIES

In April 1997, the Company established a Japanese subsidiary, Mechanical
Dynamics Japan K.K. ("MDI-Japan"), through a joint venture agreement with
ISI-Dentsu of Tokyo, Japan, the distributor of the Company's software in Japan.
The $(5,000) in minority interest in net income (loss) of subsidiaries
represents ISI Dentsu's 34% interest in the net loss of MDI-Japan during 1997.

EMPLOYEES

The number of the Company's worldwide employees increased 46.3% to 234 at
December 31, 1997, compared with 160 at December 31, 1996. Reflected in this
increase are 17 new employees who joined the Company as a result

<PAGE> 17

of the Company's acquisition of StatDesign, Inc. in October 1997. Absent the
impact of the acquisition, employment increased significantly to support the
Company's growing operations worldwide.

YEAR 2000 COMPLIANCE

The Company has completed testing to ensure its products are compliant
with the requirements to properly utilize dates beyond December 31, 1999. This
testing was limited to current versions of the Company's existing products. No
areas of non-compliance were noted which required modification to the Company's
software. Costs incurred to complete this testing were not material to the
Company's consolidated financial position or results of operations. The Company
is currently in the process of evaluating its internal information technology
infrastructure for Year 2000 compliance. The Company does not expect that the
cost to modify its information technology infrastructure to be Year 2000
compliant will be material to its consolidated financial position or results of
operations. The Company does not anticipate any material disruption in its
operations as a result of any failure by the Company to be in compliance.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents were $20.3 million at December 31, 1997,
compared to $20.6 million at December 31, 1996. The decrease in cash and cash
equivalents of $309,000 was primarily due to the $2.2 million in cash used for
capital expenditures, as well as the $1.4 million in cash used in the
acquisition of StatDesign, Inc. in October 1997. These decreases were
partially offset by the $2.7 million in cash generated from operations in 1997,
$467,000 of cash resulting from the minority investment in MDI-Japan, and
$220,000 in proceeds from stock issued by the Company during 1997.

At December 31, 1997, the Company's principal commitments consisted of
obligations under operating leases for facilities and equipment, including
approximately $1.7 million in payments due under noncancelable operating leases
during 1998. The Company had no borrowings under long-term debt arrangements at
December 31, 1997.

In April 1997, the Company established a Japanese subsidiary, MDI-Japan,
through a joint venture agreement with ISI-Dentsu of Tokyo, Japan, the
distributor of the Company's software in Japan. The Company owns 66% of
MDI-Japan, while ISI-Dentsu owns a 34% minority interest. Pursuant to the
agreement, the Company and ISI-Dentsu made combined capital contributions of
approximately $1.4 million to MDI-Japan. MDI-Japan provides consulting and
other professional services directly to customers in Japan, and supports
ISI-Dentsu in marketing the Company's software in Japan.

In June 1997, the Company entered into an agreement with its principal
bank for an unsecured $4.0 million line of credit. No borrowings were
outstanding under this agreement as of December 31, 1997. The Company's
subsidiaries in Germany, Italy, Sweden, and France also have line of credit and
overdraft facilities that provide for aggregate borrowing availability of
approximately $465,000. Approximately $45,000 in borrowings were outstanding
under these facilities as of December 31, 1997.

<PAGE> 18

Long-term cash requirements, other than for normal operating expenses, are
anticipated for the development of new software products and enhancements of
existing products, financing growth, repurchases of the Company's common stock
and the possible acquisition of software products, technologies and businesses
complementary to the Company's business. The Company believes that cash flows
from operations, together with existing cash balances, and available borrowings
will be adequate to meet the Company's cash requirements for working capital,
capital expenditures and stock repurchases for the next twelve months and the
foreseeable future. The Company has not paid dividends during the period from
1995 through 1997 and intends to continue its policy of retaining earnings to
finance future growth.

<PAGE> 19

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Board of Directors and Shareholders of Mechanical Dynamics, Inc.:

We have audited the accompanying consolidated balance sheets of MECHANICAL
DYNAMICS, INC. (a Michigan corporation) and subsidiaries as of December 31,
1997 and 1996, and the related consolidated statements of income, shareholders'
equity (deficit) and cash flows for each of the three years in the period ended
December 31, 1997. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Mechanical
Dynamics, Inc. and its subsidiaries as of December 31, 1997 and 1996, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1997 in conformity with generally
accepted accounting principles.

ARTHUR ANDERSEN LLP

Detroit, Michigan,
January 30, 1998

<PAGE> 20

MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 1997 AND 1996

<TABLE>
<CAPTION>
In thousands, except share data 1997 1996
- --------------------------------------------------------------------------------
ASSETS
------
<S> <C> <C>
Current assets:
Cash and cash equivalents.................................. $20,261 $20,570
Accounts receivable........................................ 8,000 5,019
Prepaid and deferred expenses.............................. 1,206 1,074
------- -------
Total current assets................................... 29,467 26,663
------- -------
Net property and equipment................................... 2,887 1,643
Other assets................................................. 1,793 1,506
------- -------
$34,147 $29,812
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------
Current liabilities:
Borrowings under line of credit.......................... $ 45 $ 45
Accounts payable........................................... 1,474 762
Accrued expenses........................................... 3,734 2,982
Deferred revenue........................................... 4,462 3,671
------- -------
Total current liabilities.............................. 9,715 7,460
------- -------
Minority interest............................................ 462 --
------- -------
Redeemable common stock, 0 and 20,843 shares issued and
outstanding as of December 31, 1997 and 1996,
respectively............................................... -- 167
------- -------
Shareholders' equity:
Common stock, no par value, 15,000,000 shares authorized,
5,984,061 and 5,739,592 shares issued and outstanding as
of December 31, 1997 and 1996, respectively.............. 20,838 19,583
Preferred stock, no par value, 1,000,000 shares authorized,
0 shares issued and outstanding as of December 31, 1997
and 1996, respectively................................... -- --
Retained earnings.......................................... 3,290 2,546
Cumulative translation adjustment.......................... (158) 56
------- -------
Total shareholders' equity............................. 23,970 22,185
------- -------
$34,147 $29,812
======= =======
</TABLE>

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

<PAGE> 21
MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

<TABLE>
<CAPTION>
In thousands, except share and per share data 1997 1996 1995
- ------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Revenue:
Software licenses................................... $ 17,258 $ 14,590 $ 12,338
Services............................................ 12,933 10,793 8,918
--------- --------- ---------
Total revenue................................... 30,191 25,383 21,256
--------- --------- ---------
Cost of revenue:
Software licenses................................... 791 606 728
Services............................................ 7,066 6,183 5,194
--------- --------- ---------
Total cost of revenue........................... 7,857 6,789 5,922
--------- --------- ---------
Gross profit.......................................... 22,334 18,594 15,334
--------- --------- ---------
Operating expenses:
Sales and marketing................................. 11,705 9,672 8,118
Research and development............................ 4,756 3,669 2,940
General and administrative.......................... 3,218 2,750 2,610
Purchased in-process research and development....... 1,690 -- --
--------- --------- ---------
Total operating expenses........................ 21,369 16,091 13,668
--------- --------- ---------
Operating income...................................... 965 2,503 1,666
Other income, net..................................... 791 536 9
--------- --------- ---------
Income before income taxes and minority interest...... 1,756 3,039 1,675
Provision for income taxes............................ 1,017 968 294
--------- --------- ---------
Income before minority interest....................... 739 2,071 1,381
Minority interest in net income (loss) of subsidiaries (5) -- --
--------- --------- ---------
Net income............................................ $ 744 $ 2,071 $ 1,381
========= ========= =========
CALCULATION OF NET INCOME PER SHARE
-----------------------------------
Net income............................................ $ 744 $ 2,071 $ 1,381
Accretion of value of warrants...................... -- -- 234
--------- --------- ---------
Net income available to common shareholders........... $ 744 $ 2,071 $ 1,147
========= ========= =========
Pro forma basic net income per common share........... $ 0.13 $ 0.42 $ 0.30
========= ========= =========
Pro forma basic weighted average common shares........ 5,805,936 4,990,215 3,788,702
========= ========= =========
Pro forma diluted net income per common share......... $ 0.13 $ 0.41 $ 0.30
========= ========= =========
Pro forma diluted weighted average common and common
equivalent shares................................... 5,867,753 5,070,028 3,849,824
========= ========= =========
</TABLE>

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

<PAGE> 22

MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

<TABLE>
<CAPTION>
CONVERTIBLE CLASS A CLASS B CLASS A
COMMON PREFERRED COMMON COMMON COMMON STOCK
In thousands, except share data STOCK STOCK STOCK STOCK WARRANTS
- ---------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Balance at December 31, 1994..................... $ -- $ 265 $ 5 $ 3 $ 332
Net income..................................... -- -- -- -- --
Issuance of 21,000 shares of Class A common
stock........................................ -- -- 1 -- --
Issuance of 45,000 and repurchase of 11,775
shares of Class B common stock............... -- -- -- -- --
Accretion of value of warrants................. -- -- -- -- 117
Compensation related to stock issuances........ -- -- -- -- --
Collections on subscriptions receivable........ -- -- -- -- --
Foreign currency translation adjustment........ -- -- -- -- --
------- ---------- ------ ------ -----------
Balance at December 31, 1995..................... -- 265 6 3 449
Net income..................................... -- -- -- -- --
Issuance of 11,250 shares of Class B common
stock........................................ -- -- -- -- --
Exercise of Class A common stock warrants
and issuance of 81,060 shares of Class A
common stock................................. -- -- -- -- (449)
Conversion of 354,932 shares of Convertible
preferred stock into 484,758 shares of
Class A common stock......................... -- (265) 2 -- --
Conversion of 1,178,865 shares of Class B
common stock and 2,700,772 shares of Class
A common stock into 3,879,637 shares of no
par common stock............................. 900 -- (8) (3) --
Termination of redemption privileges for
86,486 shares of redeemable common stock..... 692 -- -- -- --
Issuance of 1,880,798 shares of common stock... 17,991 -- -- -- --
Collections on subscriptions receivable........ -- -- -- -- --
Foreign currency translation adjustment........ -- -- -- -- --
------- ---------- ------ ------ -----------
Balance at December 31, 1996..................... 19,583 -- -- -- --
Net income..................................... -- -- -- -- --
Termination of redemption privileges for
20,843 shares of redeemable common stock..... 167 -- -- -- --
Issuance of 223,626 shares of common stock..... 1,088 -- -- -- --
Foreign currency translation adjustment........ -- -- -- -- --
------- ---------- ------ ------ -----------
Balance at December 31, 1997..................... $20,838 $ -- $-- $-- $ --
======= ========== ====== ====== ===========
</TABLE>

<TABLE>
<CAPTION>
ADDITIONAL RETAINED CUMULATIVE
PAID-IN EARNINGS SUBSCRIPTIONS TRANSLATION
In thousands, except share data CAPITAL (DEFICIT) RECEIVABLE ADJUSTMENT TOTAL
- ----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Balance at December 31, 1994..................... $ -- $ (671) $(28) $ 17 $ (77)
Net income..................................... -- 1,381 -- -- 1,381
Issuance of 21,000 shares of Class A common
stock........................................ 15 -- -- -- 16
Issuance of 45,000 and repurchase of 11,775
shares of Class B common stock............... 15 (1) (2) -- 12
Accretion of value of warrants................. -- (234) -- -- (117)
Compensation related to stock issuances........ 84 -- -- -- 84
Collections on subscriptions receivable........ -- -- 20 -- 20
Foreign currency translation adjustment........ -- -- -- 15 15
--------- -------- ------------ ---------- -------
Balance at December 31, 1995..................... 114 475 (10) 32 1,334
Net income..................................... -- 2,071 -- -- 2,071
Issuance of 11,250 shares of Class B common
stock........................................ 3 -- -- -- 3
Exercise of Class A common stock warrants
and issuance of 81,060 shares of Class A
common stock................................. 509 -- -- -- 60
Conversion of 354,932 shares of Convertible
preferred stock into 484,758 shares of
Class A common stock......................... 263 -- -- -- --
Conversion of 1,178,865 shares of Class B
common stock and 2,700,772 shares of Class
A common stock into 3,879,637 shares of no
par common stock............................. (889) -- -- -- --
Termination of redemption privileges for
86,486 shares of redeemable common stock..... -- -- -- -- 692
Issuance of 1,880,798 shares of common stock... -- -- -- -- 17,991
Collections on subscriptions receivable........ -- -- 10 -- 10
Foreign currency translation adjustment........ -- -- -- 24 24
--------- -------- ------------ ---------- -------
Balance at December 31, 1996..................... -- 2,546 -- 56 22,185
Net income..................................... -- 744 -- -- 744
Termination of redemption privileges for
20,843 shares of redeemable common stock..... -- -- -- -- 167
Issuance of 223,626 shares of common stock..... -- -- -- -- 1,088
Foreign currency translation adjustment........ -- -- -- (214) (214)
--------- -------- ------------ ---------- -------
Balance at December 31, 1997..................... $ -- $3,290 $ -- $(158) $23,970
========= ======== ============ ========== =======
</TABLE>

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

<PAGE> 23

MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

<TABLE>
<CAPTION>
In thousands 1997 1996 1995
- --------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income........................................................ $ 744 $ 2,071 $ 1,381
Adjustments to reconcile net income to net cash provided by
operating activities --
Purchased in-process research and development................... 1,690 -- --
Depreciation and amortization................................... 968 603 567
Provision (benefit) for deferred income taxes................... 42 (92) (95)
(Gain) loss on disposal of assets............................... 33 (11) (28)
Minority interest in net income (loss) of subsidiaries.......... (5) -- --
Changes in assets and liabilities, net of effect of acquisition --
Accounts receivable........................................... (2,304) (548) (1,304)
Prepaid and deferred expenses................................. (43) (133) (188)
Other assets.................................................. (66) 65 (102)
Accounts payable.............................................. 499 102 (76)
Accrued expenses.............................................. 580 200 1,311
Deferred revenue.............................................. 551 (19) 650
------- ------- -------
Net cash provided by operating activities................... 2,689 2,238 2,116
------- ------- -------
Cash flows from investing activities:
Acquisition of StatDesign Inc., net of cash acquired.............. (1,374) -- --
Proceeds from sale of property and equipment...................... 48 28 269
Purchases of property and equipment............................... (2,225) (894) (819)
------- ------- -------
Net cash used in investing activities....................... (3,551) (866) (550)
------- ------- -------
Cash flows from financing activities:
Minority investment in consolidated subsidiary.................... 467 -- --
Proceeds from issuance of common stock............................ 220 18,054 28
Proceeds from collections on subscriptions receivable............. -- 10 20
Net payments under line of credit agreements...................... -- (37) (738)
Payments of long-term debt........................................ -- -- (528)
------- ------- -------
Net cash provided by (used in) financing activities......... 687 18,027 (1,218)
------- ------- -------
Effect of exchange rate changes on cash............................. (134) 30 (24)
------- ------- -------
Net increase (decrease) in cash..................................... (309) 19,429 324
Cash at beginning of year........................................... 20,570 1,141 817
------- ------- -------
Cash at end of year................................................. $20,261 $20,570 $ 1,141
======= ======= =======
Supplemental disclosures of cash flow information --
Interest paid..................................................... $ 12 $ 22 $ 59
======= ======= =======
Income taxes paid................................................. $ 764 $ 753 $ 413
======= ======= =======
Supplemental schedule of noncash investing and financing activities:
Details of acquisition of StatDesign, Inc.:
Net assets, other than cash acquired............................ $ 22 $ -- $ --
Purchase price in excess of net assets acquired................. 530 -- --
Purchased in-process research and development................... 1,690 -- --
Common stock issued............................................. (868) -- --
------- ------- -------
Net cash used to acquire StatDesign, Inc.................... $ 1,374 $ -- $ --
======= ======= =======
</TABLE>

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

<PAGE> 24

MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Business

Mechanical Dynamics, Inc. (the "Company") and its subsidiaries develop,
market and support virtual prototyping software and provide consulting,
training, and maintenance services to the automotive, general machinery,
construction equipment, aerospace, defense and other industries on a worldwide
basis.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company
and its majority-owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.

In April 1997, the Company established a Japanese subsidiary, Mechanical
Dynamics Japan K.K. ("MDI-Japan"), through a joint venture agreement with
Information Services International-Dentsu, Ltd. ("ISI-Dentsu") of Tokyo, Japan,
the distributor of the Company's software in Japan. The Company owns 66% of
MDI-Japan, while ISI-Dentsu owns a 34% minority interest. Pursuant to the
agreement, the Company and ISI-Dentsu made combined capital contributions of
approximately $1.4 million to MDI-Japan. MDI-Japan provides consulting and
other professional services directly to customers in Japan and supports
ISI-Dentsu in marketing the Company's software in Japan.

Foreign Currency

The financial statements of international subsidiaries are translated
using exchange rates in effect at period end for assets and liabilities and at
average rates during the period for results of operations. The resulting
foreign currency translation adjustments are reflected as a separate component
of shareholders' equity. Foreign currency transaction gains and losses are
included in other income, net and are not material for the periods presented.

Revenue

Software licenses revenue consists primarily of license fees for the
Company's software products and, to a lesser extent, license fees from other
companies' software products licensed through the Company's European
subsidiaries. Revenue under paid-up software licensing agreements, including
licenses generated through distributors, is recognized when a customer contract
is fully executed and the software is delivered. Revenue under annual software
licensing arrangements is deferred and amortized over the terms of the
agreements. In either instance, revenue is recognized only when no significant
remaining obligations to the customer exist.

Services revenue consists primarily of revenue from software maintenance
agreements and professional services, including consulting, training and funded
research and development. Revenue related to advance payments received under
software maintenance agreements is deferred and amortized over the terms of the
agreements. Revenue from other services is recognized upon performance of the
service.

Cost of Revenue

Cost of software licenses includes software royalty fees, media costs,
payroll and other costs attributable to software documentation and distribution
and an allocation of depreciation, utilities and other overhead expenses
incurred by the Company.

<PAGE> 25

Cost of services includes payroll and overhead expenses attributable to
hotline support, consulting, training and funded research and development.

Research and Development Expenses

Product Development

Under the criteria set forth in Statement of Financial Accounting
Standards No. 86, "Accounting for the Costs of Computer Software to be Sold,
Leased or Otherwise Marketed," capitalization of software development costs
begins upon the establishment of technological feasibility of the product. The
establishment of technological feasibility and the ongoing assessment of the
recoverability of these costs require considerable judgment by management with
respect to certain external factors, including, but not limited to, anticipated
future gross product revenue, estimated economic product lives and changes in
software and hardware technology. Amounts that would have been capitalized
under this statement after consideration of the above factors were immaterial,
and therefore no software development costs have been capitalized by the
Company.

Concentration of Credit Risk

Financial instruments which potentially expose the Company to
concentrations of credit risk, as defined by Statement of Financial Accounting
Standards No. 105, consist primarily of accounts receivable. The Company's
accounts receivable are concentrated in global automotive-related companies as
well as other equipment, aerospace and defense manufacturers and the Company's
international distributor network. The Company generally does not require
collateral upon delivery of its products.

Cash and Cash Equivalents

The Company considers all highly liquid investments with maturities of 90
days or less to be cash equivalents.

Accounts Receivable

Accounts receivable includes an allowance for doubtful accounts of
$235,000 and $175,000 in 1997 and 1996, respectively.

Property and Equipment

Property and equipment is stated at cost. Office furniture and equipment
is depreciated using accelerated methods over estimated useful lives of three
to seven years. Leasehold improvements are amortized using the straight-line
method over the lesser of the respective asset's life or the life of the
related lease, generally ten years. Property and equipment consists of the
following:

<TABLE>
<CAPTION>
In thousands 1997 1996
- -------------------------------------------------------
<S> <C> <C>
Office furniture and equipment....... $4,436 $2,568
Leasehold improvements............... 765 718
------ ------
5,201 3,286
Less -- accumulated depreciation..... 2,314 1,643
------ ------
Net property and equipment...... $2,887 $1,643
====== ======
</TABLE>

<PAGE> 26

Goodwill

Included in other assets on the accompanying consolidated balance sheets
is goodwill of $1.5 million and $1.1 million as of December 31, 1997 and 1996,
respectively. Goodwill is presented net of accumulated amortization of $354,000
and $250,000 in 1997 and 1996, respectively.

Goodwill represents the unamortized cost in excess of fair value of net
assets acquired and is amortized on a straight-line basis over ten to fifteen
years. On an ongoing basis, management reviews the valuation and amortization
of goodwill. As part of this review, the Company considers the value of
projected future undiscounted cash flows attributable to the acquired
operations in evaluating potential impairment.

Net Income Per Common Share

Net income available to common shareholders is net of an equity charge in
1995 to accrete the redemption price of warrants outstanding.

For the year and the quarter ended December 31, 1997, the Company adopted
Statement of Financial Accounting Standards No. 128, "Earnings per Share." The
primary requirements of this standard include: (1) the replacement of primary
earnings per share with basic earnings per share, which eliminates the dilutive
effect of stock options and warrants; (2) the use of average share price in
applying the treasury method to compute dilution for stock options and warrants
for diluted earnings per share; and (3) a disclosure reconciling the numerator
and denominator of earnings per share calculations. All prior period per share
data presented has been restated to conform with this new statement.

The calculation of pro forma basic weighted average common shares is based
on the following: the daily weighted average number of shares of common stock
outstanding; any shares issued below fair market value for all periods
presented; the 1.5-for-1 stock split (see Note 5); and the conversion of the
preferred stock into common stock for all periods. The calculation of pro
forma diluted weighted average common shares includes the basic weighted
average common shares plus the dilutive effect of outstanding stock options and
warrants.

Use of Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities as of
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting periods. Actual results could differ from those
estimates.

Stock-Based Compensation

The Company has elected to account for stock-based compensation using the
intrinsic value method prescribed in Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees", and related interpretations.
Accordingly, compensation cost for stock options is measured as the excess, if
any, of the quoted market price of the Company's stock at the date of grant
over the amount the employee must pay to acquire the stock in the accompanying
consolidated statements of income. As supplemental information, the Company has
provided pro forma disclosure of the fair value at the date of grant of stock
options granted during 1997 and 1996 in Note 5, in accordance with the
requirements of Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("SFAS 123").

New Accounting Pronouncements

In October 1997, Statement of Position 97-2, "Software Revenue
Recognition," was issued. This pronouncement provides guidance on recognizing
revenue on software transactions. The Company will be required to adopt this
new standard for transactions entered into beginning January 1, 1998. The
Company believes that the

<PAGE> 27
implementation of this statement will not have an impact on its consolidated
financial statements or its current revenue recognition policies.

In July 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS
130") and Statement of Financial Accounting Standards No. 131, "Disclosures
About Segments of an Enterprise and Related Information" ("SFAS 131"). The
Company will be required to adopt these new standards for the year ended
December 31, 1998. SFAS 130 establishes standards for reporting and display of
comprehensive income and its components in a full set of financial statements.
SFAS 131 introduces a new model for segment reporting, called the "management
approach." The management approach is based on the way that the chief
operating decision-maker organizes segments within a company for making
operating decisions and assessing performance. The Company believes that the
implementation of these standards will not have a material effect on its
consolidated financial statements.

Reclassifications

Certain amounts in the 1996 and 1995 consolidated financial statements
have been reclassified to conform with the 1997 presentation.

(2) ACQUISITIONS

In October 1997, the Company acquired 100% of the outstanding capital
stock of StatDesign, Inc., a company based in Dearborn, Michigan. Since its
founding in 1992, StatDesign, Inc. has worked almost exclusively with the
Company's largest single customer to provide engineering software and services
for product design and development. The aggregate purchase price of
approximately $2.2 million consisted of $1.4 million in cash and 170,227 shares
of the Company's common stock valued at approximately $868,000. The
acquisition has been accounted for under the purchase method of accounting. In
connection with the acquisition, the Company recorded a one-time charge to
operations in the fourth quarter of 1997 of approximately $1.7 million,
associated with the write-off of in-process research and development acquired
in the transaction that had not reached technological feasibility. The
remaining excess of the aggregate purchase price over the fair value of the net
assets acquired of approximately $530,000 has been recognized as goodwill and
will be amortized over a ten-year period. The operating results of StatDesign,
Inc. have been included in the consolidated results of operations from the date
of acquisition.

On April 1, 1994, the Company purchased certain intangible assets and
software rights from one of its European distributors, and all outstanding
stock of the distributor's majority-owned subsidiaries in France, Germany,
Sweden, Italy and the United Kingdom. The total purchase price of approximately
$1.8 million consisted of $448,000 in cash, $526,000 in notes and $859,000
associated with 107,329 shares of the Company's Class A common stock with
redemption privileges at $8 per share. During 1997 and 1996, the redemption
privileges associated with 20,843 and 86,486 of these shares terminated,
respectively.

(3) FINANCING ARRANGEMENTS

The Company has available an unsecured bank line of credit with a maximum
borrowing capacity of $4.0 million. Borrowings on the line of credit bear
interest at the bank's prime rate of interest. No borrowings were outstanding
at December 31, 1997. The agreement expires on June 30, 1999.

The Company's subsidiaries in Germany, Italy, Sweden and France also have
line of credit and overdraft facilities that provide for aggregate borrowing
availability of approximately $465,000, at various fixed and variable interest
rates. Borrowings are collateralized by certain assets of the subsidiaries.
Borrowings outstanding under these agreements were $45,000 at December 31, 1997
and 1996.

No borrowings were outstanding under long-term debt arrangements as of
December 31, 1997 and 1996.

<PAGE> 28

(4) INCOME TAXES

A summary of income before provision for income taxes and components of
the provision for income taxes is as follows:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------
In thousands 1997 1996 1995
- ------------------------------------------------------------------------------
<S> <C> <C> <C>
Income (loss) before provision for income taxes:
Domestic...................................... $1,497 $2,874 $1,679
Foreign....................................... 259 165 (4)
-------- ------- -------
$1,756 $3,039 $1,675
======== ======= =======
Domestic provision (benefit) for income taxes:
Current....................................... $ 859 $ 973 $ 329
Deferred...................................... 42 (92) (95)
Foreign provision for income taxes:
Current....................................... 116 87 60
-------- ------- -------
Provision for income taxes...................... $1,017 $ 968 $ 294
======== ======= =======
</TABLE>

The differences between the income tax provision calculated at the United
States Federal statutory rate and the consolidated income tax provision are
summarized as follows:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------
In thousands 1997 1996 1995
- ---------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Federal statutory provision.......................................... $ 597 $1,033 $ 570
Non-deductible meals and entertainment............................. 41 28 24
Non-deductible purchased in-process research and development....... 575 -- --
Reduction in valuation reserve..................................... -- (95) (456)
Foreign losses without tax benefit................................. 5 5 33
Effect of differences between U.S. and foreign tax rates including
foreign sales corporation........................................ (66) 31 31
Tax exempt interest income......................................... (106) (34) --
Foreign withholding taxes paid, net of domestic benefit............ -- -- 92
Other, net......................................................... (29) -- --
------- ------- -------
Provision for income taxes........................................... $1,017 $ 968 $ 294
======= ======= =======
</TABLE>

Deferred income taxes represent temporary differences in the recognition
of certain items for income tax and financial reporting purposes. The
components of the net deferred income tax asset are summarized as follows:

<TABLE>
<CAPTION>
AS OF
DECEMBER 31,
---------------
In thousands 1997 1996
- -------------------------------------------------------------------------------------
<S> <C> <C>
Deferred tax assets:
Tax credits....................................................... $ -- $ 90
Property and equipment............................................ 81 95
Employee benefits................................................. 120 64
Accounts receivable............................................... 72 66
------ ------
Net deferred tax asset.............................................. $273 $315
====== ======
</TABLE>

Income taxes have been provided on all undistributed earnings of foreign
subsidiaries.

<PAGE> 29
(5) REDEEMABLE COMMON STOCK AND SHAREHOLDERS' EQUITY

On April 23, 1996, the shareholders of the Company approved an amendment
and restatement to the Company's articles of incorporation that effected (i) a
1.5-for-1 stock split of the Company's common stock, (ii) an increase in the
authorized shares of common stock to 15,000,000 shares, (iii) the conversion of
all classes of common stock to no par common stock, (iv) an increase in the
authorized number of preferred shares to 1,000,000, and (v) an amendment of the
privileges of the preferred stock. All references in the consolidated financial
statements and accompanying notes have also been adjusted to reflect the
amendment and restatement of the articles of incorporation.

Common Stock

Holders of shares of common stock are entitled to one vote per share on
all matters submitted to a vote of holders of shares of common stock, and do
not have any cumulative voting rights. In the event of a liquidation,
dissolution or winding-up of the Company, the holders of shares of common stock
are entitled to share equally and ratably in the assets of the Company, if any,
remaining after the payment of debts and liabilities of the Company, subject to
prior liquidation rights of any outstanding shares of preferred stock.

In May 1996, the Company completed an initial public offering of its
stock, which resulted in the issuance of 1,500,000 shares of common stock at a
price of $11.00 per share. In June 1996, an additional 354,750 shares were sold
by the Company at $11.00 per share, pursuant to the underwriters' exercise of
their over-allotment option.

Preferred Stock

The Board of Directors is authorized to issue up to 1,000,000 shares of
preferred stock in one or more series. Under each issuance of a series of
preferred stock, the Board of Directors is permitted to fix the designations,
preferences, powers and relative rights and restrictions thereof, including
without limitation, the dividend rate, conversion rights, voting rights,
redemption price, and liquidation preference.

Convertible Preferred Stock

On February 8, 1996, the Board of Directors authorized the Company to
redeem all outstanding shares of convertible preferred stock. The holders of
convertible preferred shares had the right to convert such shares into shares
of Class A common stock in lieu of accepting cash redemption payments. As of
April 11, 1996, all holders of convertible preferred stock exercised their
right to convert their shares into Class A common stock. Based on a formula in
the agreement, each share of convertible preferred stock was converted into
approximately 1.37 shares of Class A common stock.

Class A and Class B Common Stock

In April 1996, the Company amended and restated its Articles of
Incorporation to automatically convert each share of Class A common stock and
each share of Class B common stock into one share of common stock.

Class A Common Stock Warrants

In March 1990, April 1991, and September 1992, 124,155, 23,280, and 14,685
nonnegotiable warrants to acquire Class A common stock of the Company,
respectively, were issued and attached to the Company's subordinated debt. Upon
repayment of this debt in March 1994, the warrants became exercisable through
March 1996. Paid-in capital and retained earnings (deficit) were charged to
accrete the total redemption value of these warrants, which was calculated
based upon a redemption price from a formula in the warrant agreements. The
warrants did not accrete any additional value subsequent to December 31, 1995.
The redemption price was calculated by taking the difference between the
warrant exercise price of $0.75 per share and the ratio of consolidated revenue
to shares of stock outstanding, adjusted for any shares issued subsequent to
March 26, 1990 at prices below $0.75 per share.

<PAGE> 30

The Company was notified on March 11, 1996, that the holder of one-half of
the warrants would exercise their right to purchase 81,060 shares of the
Company's Class A common stock at a price of $0.75 per share. The remaining
warrants were redeemed by the Company in 1996 for a cash value of $449,000;
these warrants were reflected as accrued liabilities in the Company's
consolidated balance sheet as of December 31, 1995.

Employee Stock Purchase Plan

The Company's Employee Stock Purchase Plan (the "Purchase Plan") was
adopted by the Company's Board of Directors in March 1996. A total of 300,000
shares of common stock has been reserved for issuance under the Purchase Plan.
The Purchase Plan provides that the Company will sell shares to employees who
elect to participate in the Purchase Plan at a price equal to 85% of the lesser
of the fair market value of the common stock on (i) the first trading day of an
offering period or (ii) the last trading day of such offering period.

Under the Purchase Plan, the Company issued 33,899 and 17,213 shares of
common stock in 1997 and 1996, respectively, to various employees at a weighted
average price of $5.97 per share in 1997 and $11.79 per share in 1996.

1996 Stock Incentive Plan For Key Employees

The Company's 1996 Stock Incentive Plan for Key Employees (the "Stock
Option Plan") was adopted by the Company's Board of Directors in March 1996.
Under the Stock Option Plan, options will be granted or restricted stock will
be awarded for the purpose of attracting and motivating key employees of the
Company. The Stock Option Plan provides for (i) the grant of "incentive stock
options" within the meaning of Section 422 of the Internal Revenue Code, (ii)
the grant of "nonqualified stock options" (options which do not meet the
requirements of Section 422), and (iii) the award of restricted stock. Subject
to certain provisions outlined in the Stock Option Plan, the Compensation
Committee of the Board of Directors will determine which key employees will be
granted options or awarded restricted stock, the number of options granted or
shares awarded and other terms and conditions applicable to each award or
grant. A total of 650,000 shares of common stock has been reserved for
issuance under the Stock Option Plan.

Stock option activity for this plan is summarized below:

<TABLE>
<CAPTION>
WTD. AVG.
NUMBER PRICE EXERCISE
OF SHARES PER SHARE PRICE
- -----------------------------------------------------------------------------
<S> <C> <C> <C>
Outstanding at December 31, 1995..... --
Granted............................ 182,500 $9.00 - $13.50 $11.47
--------
Outstanding at December 31, 1996..... 182,500 $9.00 - $13.50 $11.47
Granted............................ 329,000 $6.50 - $ 9.13 $ 7.75
Canceled........................... (132,200) $6.50 - $13.50 $11.81
--------
Outstanding at December 31, 1997..... 379,300 $6.69 - $ 9.13 $ 8.12
========
</TABLE>

There were 82,500 options exercisable under the Stock Option Plan as of
December 31, 1997 with a weighted average exercise price of $9.00 per share.
The remaining options vest over a four-year period beginning on the date of
grant at 25% per year, and expire five years from the date they are granted.
Options outstanding under the Stock Option Plan have a weighted average
remaining contractual life of 4.1 years as of December 31, 1997. No options
were exercisable under the Stock Option Plan as of December 31, 1996.

Non-Employee Director Stock Option Plan

The Company's Non-Employee Director Stock Option Plan (the "Director Stock
Option Plan") was adopted by the Company's Board of Directors in March 1996.
The Director Stock Option Plan provides for the grant of "nonqualified stock
options" to purchase shares of common stock. Upon appointment to the Board of
Directors, each newly appointed non-employee director will receive an option to
purchase 5,000 shares of common stock of the

<PAGE> 31
Company. Furthermore, immediately following each annual meeting of shareholders
of the Company, each non-employee director who has served as a director for at
least six months will automatically be granted an option to purchase 5,000
shares of common stock of the Company. The exercise price of any option will be
equal to the market price of the common stock at the time of grant. Each
option, if not sooner terminated as provided in the Director Stock Option Plan,
will have a five-year term from the date of grant and will vest and become
exercisable in full on the first anniversary of the date of grant. A total of
100,000 shares of common stock have been reserved for issuance under the
Director Stock Option Plan.

Stock option activity for this plan is summarized below:

<TABLE>
<CAPTION>
NUMBER PRICE
OF SHARES PER SHARE
- -------------------------------------------------------------------------------------
<S> <C> <C>
Outstanding at December 31, 1995..................... --
Granted............................................ 20,000 $11.00
--------
Outstanding at December 31, 1996..................... 20,000 $11.00
Granted............................................ 20,000 $ 9.13
--------
Outstanding at December 31, 1997..................... 40,000 $9.13 - $11.00
=========
</TABLE>

There were 20,000 options exercisable under the Director Stock Option Plan
as of December 31, 1997. Options outstanding under the Director Stock Option
Plan have a weighted average remaining contractual life of 3.8 years as of
December 31, 1997.

1995 Amended and Restated Stock Purchase Plan

In March 1996, the Company's 1995 Amended and Restated Stock Purchase Plan
(the "1995 Plan") was terminated by the Board of Directors.

Under the 1995 Plan, the Board was permitted to issue shares of Class B
common stock to attract, retain and motivate key employees. The price of such
shares was determined by the Board when the opportunity to purchase shares was
presented, but could not be less than the book value of the stock.

In addition, under the 1995 Plan, the Board from time to time also granted
stock options to attract, retain and motivate certain key executive officers.
Stock option activity for this plan is summarized below:

<TABLE>
<CAPTION>
NUMBER PRICE
OF SHARES PER SHARE
- --------------------------------------------------------------------------------------
<S> <C> <C>
Outstanding at December 31, 1994.................... 45,000 $0.16 - $0.25
Exercised......................................... (18,750) $0.16
--------
Outstanding at December 31, 1995.................... 26,250 $0.25
Exercised......................................... (18,750) $0.25
Canceled.......................................... (7,500) $0.25
--------
Outstanding at December 31, 1996 and 1997........... --
========
</TABLE>

1993 Stock Option Plan

In March 1996, the Company's 1993 Stock Option Plan (the "1993 Plan") was
terminated by the Board of Directors.

<PAGE> 32
Under the 1993 Plan, the Board was permitted to grant options to purchase
shares of Class A common stock to certain key employees. The price of such
options was determined by the Board when the options were granted, but could
not be less than the book value of the stock. Management determined that all
options granted under the 1993 Plan were at exercise prices equal to or in
excess of fair market value. Stock option activity for this plan is summarized
below:

<TABLE>
<CAPTION>
NUMBER PRICE
OF SHARES PER SHARE
- --------------------------------------------------------------------------------------------
<S> <C> <C>
Outstanding at December 31, 1994, 1995 and 1996.................. 61,671 $0.93
Exercised...................................................... (19,500) $0.93
--------
Outstanding at December 31, 1997................................. 42,171 $0.93
========
</TABLE>

All outstanding options under the 1993 Plan were exercisable at December 31,
1997, and expire in April 1998.

Stock-Based Compensation

Using the intrinsic value method of accounting for the value of stock
options granted during 1997 and 1996, no compensation cost was recorded in the
accompanying consolidated statements of income. There were no stock options
granted during 1995. Had compensation cost been determined based on the fair
value at the date of grant for awards in 1997 and 1996 consistent with the
provisions of SFAS 123, net income and net income per share would have been
reduced to the pro forma amounts indicated below:

<TABLE>
<CAPTION>
In thousands, except per share data 1997 1996
- -------------------------------------------------------------------------------
<S> <C> <C>
Net Income - as reported...................................... $ 744 $2,071
Net Income - pro forma........................................ $ 406 $1,698

Diluted net income per share - as reported.................... $0.13 $ 0.41
Diluted net income per share - pro forma...................... $0.07 $ 0.33
</TABLE>

The weighted average estimated fair value of stock options granted during
1997 and 1996 was $3.98 and $5.00, respectively. The fair value of each option
grant was estimated on the date of grant using the Black-Scholes option-pricing
model. Because the SFAS 123 method of accounting has not been applied to
options granted prior to January 1, 1995, the resulting pro forma compensation
cost may not be representative of that to be expected in future years. The
following weighted average assumptions were used in valuing the option grants:

<TABLE>
<CAPTION>
1997 1996
- ----------------------------------------------------------------------------
<S> <C> <C>
Expected life (years).......................................... 5.0 5.0
Interest rate.................................................. 6.0% 6.5%
Volatility..................................................... 0.8 0.4
Dividend yield................................................. 0.0% 0.0%
</TABLE>

<PAGE> 33
(6) COMMITMENTS AND CONTINGENCIES

Employee Benefit Plans

The Company maintains a 401(k) plan covering substantially all of its
employees. During 1997 and 1996, the Company matched 40% of qualified employee
contributions, up to a maximum of 2.4% of eligible compensation. During 1995,
under the plan, the Company provided matching contributions equal to 25% of
qualified employee contributions, up to a maximum of 1.5% of each employee's
eligible compensation. In 1997, 1996 and 1995, the Company contributed
$180,000, $150,000 and $71,000, respectively, to the plan.

Lease Commitments

The Company and its subsidiaries lease office space and certain equipment
under noncancelable operating lease agreements. Future minimum lease payments
at December 31, 1997 are as follows:

<TABLE>
<CAPTION>
In thousands
- -------------------------------------------------------------------
<S> <C>
1998.................................................... $1,745
1999.................................................... 1,166
2000.................................................... 588
2001.................................................... 8
2002.................................................... 2
Thereafter.............................................. --
------
$3,509
======
</TABLE>

Total lease expense amounted to $2.0 million, $2.0 million and $1.9
million in 1997, 1996 and 1995, respectively.

Royalty Agreements

The Company has entered into various agreements which generally provide
for royalty payments by the Company based on a percentage of revenue derived
through the licensing of certain software products. Royalty expense under these
agreements amounted to approximately $612,000, $480,000 and $469,000 in 1997,
1996 and 1995, respectively.

(7) LITIGATION

The Company is party to routine litigation arising in the normal course of
business. In the opinion of management, the liabilities resulting from these
proceedings, if any, will not be material to the Company's consolidated
financial position or results of operations.

<PAGE> 34
(8) GEOGRAPHIC OPERATIONS AND SEGMENT INFORMATION

The following table summarizes selected financial information of the
Company's operations by geographic location:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------
In thousands 1997 1996 1995
- -----------------------------------------------------------------------------
<S> <C> <C> <C>
Revenue:
North America
United States................................ $10,340 $ 8,250 $ 7,172
Canada....................................... 153 128 16
Europe
Germany...................................... 4,380 4,217 3,660
Other European countries..................... 5,653 5,535 4,576
Asia/Pacific
Japan........................................ 7,324 5,424 4,416
Other Asian countries........................ 2,341 1,829 1,416
------- ------- -------
Total revenue.............................. $30,191 $25,383 $21,256
======= ======= =======
Operating contribution:
North America
United States................................ $ 3,229 $ 2,940 $ 2,496
Canada....................................... 89 87 6
Europe
Germany...................................... 1,377 1,315 1,056
Other European Countries..................... 1,836 1,686 1,318
Asia/Pacific
Japan........................................ 2,020 1,953 1,546
Other Asian countries........................ 623 658 496
------- ------- -------
Total operating contribution............... 9,174 8,639 6,918
Unallocated expenses, net...................... (7,418) (5,600) (5,243)
------- ------- -------
Income before taxes and minority interest.. $ 1,756 $ 3,039 $ 1,675
======= ======= =======
Identifiable assets:
North America
United States................................ $27,613 $25,816 $ 4,968
Europe
Germany...................................... 1,124 1,199 1,270
Other European countries..................... 3,580 2,797 3,100
Asia/Pacific
Japan........................................ 1,788 -- --
Other Asian countries........................ 42 -- --
------- ------- -------
Total identifiable assets.................. $34,147 $29,812 $ 9,338
======= ======= =======
</TABLE>

One customer accounted for approximately 10.6%, 11.8% and 13.2% of total
revenue in the years ended December 31, 1997, 1996 and 1995, respectively.

Unallocated expenses, net consist of general corporate expenses, internal
research and product development expenses, interest expense and interest
income. In 1997, these expenses also include the write-off of approximately
$1.7 million of purchased in-process research and development related to the
acquisition of StatDesign, Inc.

<PAGE> 35
(9) QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

The following table summarizes selected unaudited quarterly financial
information for 1997 and 1996. The Company believes all adjustments, consisting
of normal recurring adjustments considered necessary for a fair presentation,
have been included in the selected quarterly information:

<TABLE>
<CAPTION>
THREE MONTHS ENDED YEAR ENDED
------------------------------------------------- -------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31, DECEMBER 31,
In thousands, except per share data 1997 1997 1997 1997 1997
- -----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Revenue........................................ $6,701 $7,205 $7,679 $8,606 $30,191
Operating income (loss)........................ 514 628 693 (870) 965
Net income (loss).............................. 477 589 649 (971) 744
Basic net income (loss) per common share....... $ 0.08 $ 0.10 $ 0.11 $(0.16) $ 0.13
Diluted net income (loss) per common share..... $ 0.08 $ 0.10 $ 0.11 $(0.16) $ 0.13

</TABLE>

<TABLE>
<CAPTION>
THREE MONTHS ENDED YEAR ENDED
------------------------------------------------ --------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31, DECEMBER 31,
In thousands, except per share data 1996 1996 1996 1996 1996
- -----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Revenue....................................... $6,048 $6,241 $6,663 $6,431 $25,383
Operating income.............................. 573 744 812 374 2,503
Net income.................................... 371 561 713 426 2,071
Basic net income per common share............. $ 0.10 $ 0.12 $ 0.12 $ 0.07 $ 0.42
Diluted net income per common share........... $ 0.10 $ 0.12 $ 0.12 $ 0.07 $ 0.41
</TABLE>

(10) SUBSEQUENT EVENT

In January 1998, the Company acquired 100% of the outstanding capital
stock of Design Technologies Asia Pte. Ltd. ("DTI"), a provider of mechanical
design simulation software embedded in the AutoCAD and Mechanical Desktop
product lines from Autodesk, Inc. The aggregate purchase price of
approximately $1.3 million consisted of $563,000 in cash and 142,540 shares of
the Company's common stock valued at approximately $732,000. The acquisition
has been accounted for under the purchase method of accounting. In connection
with the acquisition, the Company intends to record a non-recurring charge to
operations in the first quarter of 1998 of approximately $1.0 to $1.2
million, associated with the write-off of in-process research and development
acquired in the transaction that had not reached technological feasibility.
The remaining excess of the aggregate purchase price over the fair value of the
net assets acquired will be recognized as goodwill and amortized over a
ten-year period.

<PAGE> 36
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

PART III

Certain information required by Part III is omitted from this report in
that the Registrant will file a definitive proxy statement pursuant to
Regulation 14A (the "Proxy Statement") not later than 120 days after the end of
the fiscal year covered by this report and certain information included therein
is incorporated herein by reference. Only those sections of the Proxy
Statement that specifically address the items set forth herein are incorporated
by reference.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Information with respect to the directors of the Company is incorporated by
reference to the Company's Proxy Statement for the 1998 Annual Meeting of
Shareholders scheduled to be held on May 14, 1998.

The executive officers of the Company as of March 1, 1998 are listed
below:

<TABLE>
<CAPTION>
NAME AGE POSITION
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Michael E. Korybalski......................... 51 Chief Executive Officer, Chairman of the Board and Director
Robert R. Ryan................................ 40 President, Chief Operating Officer, and Director
Michael Hoffmann.............................. 41 Senior Vice President -- Worldwide Sales & Service
David Peralta................................. 30 Vice President, Chief Financial Officer and Treasurer
</TABLE>

Michael E. Korybalski, a co-founder of MDI, is currently Chief Executive
Officer, Chairman of the Board and a director of the Company. From 1984 to
February 1997, Mr. Korybalski served as President of the Company. From 1977 to
1984, Mr. Korybalski served as Vice President and General Manager of the
Company. From 1973 to 1977, he was employed as a product engineer with Ford
Motor Company. Mr. Korybalski holds B.S.E. and M.S.E. degrees in mechanical
engineering, as well as an M.B.A., from the University of Michigan.

Robert R. Ryan became the President of the Company in February 1997 and
since 1991 has served as the Chief Operating Officer of the Company. Dr. Ryan
was elected a director of the Company in May 1997. Dr. Ryan served as the
Company's Executive Vice President from 1991 to February 1997. From 1988
through 1991, Dr. Ryan served as the Company's Vice President of Product
Development. Before joining the Company, Dr. Ryan held various positions in
sales and engineering services at Structural Dynamics Research Corporation, and
served briefly on the engineering faculty at the University of Michigan. Dr.
Ryan holds a B.S. degree from the University of Cincinnati and M.S. and Ph.D.
degrees in applied mechanics from Stanford University.

Michael Hoffmann became the Company's Senior Vice President -- Worldwide
Sales and Service in November 1997. Dr. Hoffman served as the Company's Vice
President -- European Operations from November 1996 to November 1997. Dr.
Hoffmann served as the Company's Managing Director -- European Operations from
1994 through February 1997. From 1993 through 1994, Dr. Hoffmann served as
Managing Director of TEDAS Mechanical Systems GmbH, a shareholder of the
Company. From 1991 through 1992, he served as Technical Director of TEDAS GmbH.
Dr. Hoffmann holds masters and doctorate degrees in civil engineering from the
Technological University of Darmstadt.

David Peralta became the Company's Vice President, Chief Financial Officer
and Treasurer in February 1997, and served as Controller of the Company from
1993 to February 1997. From 1992 to 1993, Mr. Peralta served as Assistant
Corporate Controller at OVAKO Ajax, Inc. From 1989 through 1992, he served as
an auditor at Coopers & Lybrand. Mr. Peralta is a licensed Certified Public
Accountant in the State of Michigan. Mr. Peralta holds a bachelors degree in
accounting from the University of Michigan.

<PAGE> 37

ITEM 11. EXECUTIVE COMPENSATION

The information required by this Item is incorporated by reference to the
Company's Proxy Statement for the 1998 Annual Meeting of Shareholders scheduled
to be held on May 14, 1998.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this Item is incorporated by reference to the
Company's Proxy Statement for the 1998 Annual Meeting of Shareholders scheduled
to be held on May 14, 1998.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

None.

<PAGE> 38

PART IV

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

ITEM 14(a)1. FINANCIAL STATEMENTS

Report of Independent Public Accountants
Consolidated Balance Sheets as of December 31, 1997 and 1996
Consolidated Statements of Income for the Years Ended December 31, 1997, 1996
and 1995
Consolidated Statements of Shareholders' Equity (Deficit) for the Years Ended
December 31, 1997, 1996 and 1995
Consolidated Statements of Cash Flows for the Years Ended December 31, 1997,
1996 and 1995
Notes to Consolidated Financial Statements

ITEM 14(a)2. FINANCIAL STATEMENT SCHEDULES

None.

ITEM 14(a)3. EXHIBITS

<TABLE>
<CAPTION>
NUMBER EXHIBIT
- --------------------------------------------------------------------------------------------------
<S> <C>
(2) Joint Venture Agreement between Mechanical Dynamics, Inc. and Information Services
International - Dentsu, Ltd., incorporated herein by reference to Exhibit 2 to the
Company's previously filed Form 10-Q for the quarter ended March 31, 1997
(3.1) Restated Articles of Incorporation, incorporated herein by reference to Exhibit 3.2
to the Company's Registration Statement on Form S-1, Registration No. 333-2900
(3.2) Restated Bylaws, incorporated herein by reference to Exhibit 3.4 to the Company's
Registration Statement on Form S-1, Registration No. 333-2900
(4.2) Line of Credit Demand Note between KeyBank National Association and the Company dated
June 30, 1997, incorporated herein by reference to Exhibit 4.2 to the Company's
previously filed Form 10-Q for the quarter ended June 30, 1997
(10.1) Employment Agreement between the Company and Michael E. Korybalski, as amended
(10.2) Employment Agreement between the Company and Robert R. Ryan, as amended
(11) Statement Re Computation Of Per Share Earnings Per Share
(21) Subsidiaries Of The Registrant
(23.1) Consent Of Independent Public Accountants
(27) Financial Data Schedule
</TABLE>

ITEM 14(b). REPORTS ON FORM 8-K

No reports on Form 8-K were filed by the Company during the year ended
December 31, 1997.

<PAGE> 39

SIGNATURES

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

Dated: March 23, 1998 MECHANICAL DYNAMICS, INC.
(Registrant)
By: /s/ Michael E. Korybalski
--------------------------------
Michael E. Korybalski
Chairman of the Board

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

<TABLE>
<CAPTION>
SIGNATURES TITLE DATE
---------- ----- ----
<S> <C> <C>
/s/ Michael E. Korybalski Chairman of the Board, March 23, 1998
- -------------------------- Chief Executive Officer,
Michael E. Korybalski and Director
(Principal Executive Officer)

/s/ Robert R. Ryan President, Chief Operating Officer March 23, 1998
- -------------------------- and Director
Robert R. Ryan

/s/ David Peralta Chief Financial Officer March 23, 1998
- -------------------------- (Principal Financial and
David Peralta Accounting Officer)

/s/ Herbert S. Amster Director March 23, 1998
- --------------------------
Herbert S. Amster

/s/ John C. Angell Director March 23, 1998
- --------------------------
John C. Angell

/s/ David E. Cole Director March 23, 1998
- --------------------------
David E. Cole

/s/ Joseph F. Gloudeman Director March 23, 1998
- --------------------------
Joseph F. Gloudeman

/s/ Mitchell I. Quain Director March 23, 1998
- --------------------------
Mitchell I. Quain
</TABLE>

<PAGE> 40

INDEX TO EXHIBITS

NUMBER EXHIBIT TITLE
- --------------------------------------------------------------------------------
(2) Joint Venture Agreement between Mechanical Dynamics, Inc. and
Information Services International - Dentsu, Ltd., incorporated
herein by reference to Exhibit 2 to the Company's previously filed
Form 10-Q for the quarter ended March 31, 1997.

(3.1) Restated Articles of Incorporation, incorporated herein by reference
to Exhibit 3.2 to the Company's Registration Statement on Form S-1,
Registration No. 333-2900

(3.2) Restated Bylaws, incorporated herein by reference to Exhibit 3.4 to
the Company's Registration Statement on Form S-1, Registration No.
333-2900

(4.2) Line of Credit Demand Note between KeyBank National Association and
the Company dated June 30, 1997, incorporated herein by reference to
Exhibit 4.2 to the Company's previously filed Form 10-Q for the
quarter ended June 30, 1997.

(10.1) Employment Agreement between the Company and Michael E. Korybalski,
as amended

(10.2) Employment Agreement between the Company and Robert R. Ryan, as
amended

(11) Statement Re Computation Of Per Share Earnings

(21) Subsidiaries Of The Registrant

(23.1) Consent Of Independent Public Accountants

(27) Financial Data Schedule

<PAGE> 1
EXHIBIT 10.1

THIRD AMENDMENT TO EMPLOYMENT AGREEMENT

THIS THIRD AMENDMENT, made as of the 1st day of March, 1997, by and
between MECHANICAL DYNAMICS, INC. a Michigan corporation (the "Company"),
having offices located at 2301 Commonwealth Blvd., Ann Arbor, Michigan 48105,
and MICHAEL E. KORYBALSKI, of Ann Arbor, Michigan ("Employee"), for the purpose
of amending that certain Employment Agreement between the Company and Employee
dated as of April 1, 1994, and amended as of March 1, 1995, and as of March 1,
1996 (collectively, the "Employment Agreement").

WITNESSETH:

WHEREAS, the Company and Employee desire to extend the Employment Agreement
and to modify certain provisions thereof and to confirm the same herein.

NOW, THEREFORE, in consideration of the foregoing and of the mutual
covenants contained herein and in the Employment Agreement, the parties hereto
agree as follows:

A. Section 1 of the Employment Agreement is hereby amended to delete the
office, obligations and duties of President of the Company, effective as of
February 13, 1997.

B. Section 2 of the Employment Agreement is hereby amended to extend the
term of said Agreement through March 31, 2000.

C. Section 7 of the Employment Agreement is hereby amended by adding
thereto a new section 7.5 to read as follows:

" 7.5 Release. Anything contained in this Section 7 to the contrary
notwithstanding, the payment of any sums to Employee under subsections 7.1,
7.2 or 7.4 hereof, shall be conditioned upon (i) Employee executing and
delivering to the Company the Full And Final Release attached hereto as
Attachment II (the "Release") and (ii) in the event Employee is over forty
(40) years of age on the date of execution of the Release, upon Employee
not exercising his right to revoke said Release after having executed it."

D. Except as expressly modified herein, the Employment Agreement shall
remain in full force and effect in accordance with its original terms.

IN WITNESS WHEREOF, the parties hereto have duly executed this Third
Amendment as of the day and date first above written.

WITNESS: COMPANY
MECHANICAL DYNAMICS, INC.

Leanne K. Chaka By: Robert R. Ryan
- -------------------- ----------------------------
Robert R. Ryan, President

EMPLOYEE

Leanne K. Chaka Michael E. Korybalski
- --------------------- -------------------------------
Michael E. Korybalski

<PAGE> 1
EXHIBIT 10.2

THIRD AMENDMENT TO EMPLOYMENT AGREEMENT

THIS THIRD AMENDMENT, made as of the 1st day of March, 1997, by and
between MECHANICAL DYNAMICS, INC., a Michigan corporation (the "Company"),
having offices located at 2301 Commonwealth Blvd, Ann Arbor, Michigan 48105,
and ROBERT R. RYAN, of Brighton, Michigan ("Employee"), for the purpose of
amending that certain Employment Agreement between the Company and Employee
dated as of April 1, 1994, and amended as of March 1, 1995, and as of March 1,
1996 (collectively, the "Employment Agreement").

WITNESSETH:

WHEREAS, the Company and Employee desire to extend the Employment
Agreement and to modify certain provisions thereof and to confirm the same
herein.

NOW, THEREFORE, in consideration of the foregoing and of the mutual
covenants contained herein and in the Employment Agreement, the parties hereto
agree as follows:

A. Section 1 of the Employment Agreement is hereby amended in its
entirety to delete the office, obligations and duties of Executive Vice
President of the Company and to substitute therefor the office, obligations and
duties of President of the Company, effective as of February 13, 1997.

B. Section 2 of the Employment Agreement is hereby amended to extend
the term of said Agreement through March 31, 1999.

C. Section 7 of the Employment Agreement is hereby amended by adding
thereto a new section 7.5 to read as follows:

IN WITNESS WHEREOF, the parties hereto have duly executed this Third
Amendement as of the day and date first above written.

WITNESS: COMPANY
MECHANICAL DYNAMICS, INC.

Leanne K. Chaka By: Michael E. Korybalski
- ------------------------ -------------------------
Michael E. Korybalski
Chief Executive Officer

EMPLOYEE

Leanne K. Chaka Robert R. Ryan 5/23/97
- ------------------------- -----------------------------
Robert R. Ryan

-2-

<PAGE> 1
EXHIBIT 11

MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

STATEMENT RE COMPUTATION OF PER SHARE EARNINGS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

in thousands, except share and per share data 1997 1996 1995
- --------------------------------------------------------------------------------------------------------------------
BASIC EARNINGS PER SHARE:
<S> <C> <C> <C>
Net income...................................................... $ 744 $ 2,071 $ 1,381
Accretion of value of warrants.................................. -- -- 234
------------- ------------- -------------
Net income available to common shareholders..................... $ 744 $ 2,071 $ 1,147
============= ============= =============

Weighted average common shares outstanding...................... 5,805,936 4,990,215 3,256,694
Shares issued below fair market value........................... -- -- 47,250
Converted preferred shares...................................... -- -- 484,758
------------- ------------- -------------
Pro forma adjusted shares outstanding 5,805,936 4,990,215 3,788,702
============= ============= =============
Pro forma basic net income per common share..................... $ 0.13 $ 0.42 $ 0.30
============= ============= =============

DILUTED EARNINGS PER SHARE:
Net income available to common shareholders..................... $ 744 $ 2,071 $ 1,147
============= ============= =============

Weighted average common shares outstanding...................... 5,805,936 4,990,215 3,256,694
Shares issued below fair market value........................... -- -- 47,250
Converted preferred shares...................................... -- -- 484,758
Effect of stock options and warrants............................ 61,817 79,813 61,122
------------- ------------- -------------
Pro forma adjusted shares outstanding 5,867,753 5,070,028 3,849,824
============= ============= =============
Pro forma diluted net income per common share................... $ 0.13 $ 0.41 $ 0.30
============= ============= =============
</TABLE>

<PAGE> 1

EXHIBIT 21

MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

SUBSIDIARIES OF THE REGISTRANT
<TABLE>
<CAPTION>

LEGAL ENTITY INCORPORATION OWNERSHIP
- ---------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Mechanical Dynamics, Inc. Michigan, USA

MDI International, Inc. Michigan, USA 100% owned by Mechanical Dynamics, Inc.

Mechanical Dynamics FSC, Inc. Barbados 100% owned by Mechanical Dynamics, Inc.

Mechanical Dynamics GmbH Germany 100% owned by Mechanical Dynamics, Inc.

Mechanical Dynamics SarL France 100% owned by Mechanical Dynamics, Inc.

Mechanical Dynamics International, Ltd. United Kingdom 100% owned by Mechanical Dynamics, Inc.

Mechanical Dynamics Sweden AB Sweden 100% owned by Mechanical Dynamics, Inc.

Mechanical Dynamics Italy srl Italy 100% owned by Mechanical Dynamics, Inc.

MEC.Design srl Italy 99% owned by Mechanical Dynamics Italy srl

Mechanical Dynamics Japan K.K. Japan 66% owned by Mechanical Dynamics, Inc.
</TABLE>

<PAGE> 1

EXHIBIT 23.1

MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES

CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS

As independent public accountants, we hereby consent to the incorporation of
our reports included in this Form 10-K, into the Company's previously filed
Registration Statement File No. 333-17957.

March 23, 1998, ARTHUR ANDERSEN LLP
Detroit, Michigan

<ARTICLE> 5
<CIK> 0001011451
<NAME> MECHANICAL DYNAMICS, INC.
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-END> DEC-31-1997
<CASH> 20261
<SECURITIES> 0
<RECEIVABLES> 8235
<ALLOWANCES> 235
<INVENTORY> 0
<CURRENT-ASSETS> 29467
<PP&E> 5201
<DEPRECIATION> 2314
<TOTAL-ASSETS> 34147
<CURRENT-LIABILITIES> 9715
<BONDS> 0
0
0
<COMMON> 20838
<OTHER-SE> 3132
<TOTAL-LIABILITY-AND-EQUITY> 34147
<SALES> 0
<TOTAL-REVENUES> 30191
<CGS> 0
<TOTAL-COSTS> 29226
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 1756
<INCOME-TAX> 1017
<INCOME-CONTINUING> 744
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 744
<EPS-PRIMARY> 0.13
<EPS-DILUTED> 0.13

</TABLE>