FLAG INVESTORS TELEPHONE INCOME FUND INC, 497, 1998-02-26

FLAG INVESTORS TELEPHONE INCOME FUND INC
497, 1998-02-26

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<PAGE>
Supplement dated February 25, 1998
to Prospectus dated February 25, 1998 of
Flag Investors Telephone Income Fund, Inc.
(Institutional Shares)

The Prospectus dated February 25, 1998 for the Institutional Shares
of Flag Investors Telephone Income Fund, Inc. (the "Fund") is hereby amended
and supplemented by the following:

On December 18, 1997, the Fund's Board of Directors voted, subject to
shareholder approval, to approve proposals (i) changing the Fund's investment
objective from "current income and long-term growth of capital without undue
risk" to "to maximize total return" and (ii) replacing the Fund's fundamental
investment policy requiring that at least 65% of the Fund's assets be invested
in securities of issuers in the telephone industry, with a policy requiring
that at least 65% of the Fund's assets be invested in securities of issuers in
the communications field. These proposals will be submitted to shareholders of
record of the Fund as of the close of business on January 26, 1998 for their
approval at a meeting expected to be held in early April of 1998 and, if both
are approved, would go into effect on or about May 1, 1998. In addition, if
the proposals are approved, it is contemplated that the Fund's name will be
changed to the Flag Investors Communications Fund, Inc.; the Fund's stable
quarterly dividend will be changed to a quarterly dividend equal to the per
share amount of the applicable class' accumulated undistributed net income;
and the Fund's non-fundamental investment policy of investing at least 65% of
its assets in income-producing securities (including debt obligations) of
issuers in the telephone and other industries will be rescinded.

PLEASE RETAIN THIS SUPPLEMENT FOR FUTURE REFERENCE.

<PAGE>

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[GRAPHIC OMITTED]
FLAG INVESTORS

TELEPHONE INCOME FUND, INC.

(Institutional Shares)

Prospectus & Application -- February 25, 1998
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This mutual fund (the "Fund") is designed to provide current income and
long-term growth of capital without undue risk primarily by investing in common
stock, securities convertible thereto and debt obligations of companies in the
telephone industry and in income-producing securities (including debt
obligations) of issuers in the telephone or other industries.

Flag Investors Institutional Shares of the Fund ("Institutional Shares") are
available through your securities dealer or the Fund's transfer agent and may
be purchased only by eligible institutions or by clients of investment advisory
affiliates of BT Alex. Brown Incorporated ("BT Alex. Brown"). (See "How to
Invest in Institutional Shares.")

This Prospectus sets forth basic information that you should know about the
Fund prior to investing. You should retain it for future reference. A Statement
of Additional Information dated May 1, 1997, as supplemented through February
25, 1998, has been filed with the Securities and Exchange Commission (the "SEC")
and is hereby incorporated by reference. It is available upon request and
without charge by calling the Fund at (800) 767-FLAG.

TABLE OF CONTENTS

Fee Table ............................................................... 1
Financial Highlights .................................................... 2
Investment Program ...................................................... 4
Investment Restrictions ................................................. 5
How to Invest in Institutional Shares ................................... 6
How to Redeem Institutional Shares ...................................... 7
Telephone Transactions .................................................. 7
Dividends and Taxes ..................................................... 7
Management of the Fund .................................................. 8
Investment Advisor and Sub-Advisor ...................................... 8
Distributor ............................................................. 9
Custodian, Transfer Agent and
Accounting Services .................................................. 10
Performance Information ................................................. 10
General Information ..................................................... 10
Application ............................................................ A-1

THE FUND'S SHARES ARE NOT DEPOSITS OR OBLIGATIONS OF, OR GUARANTEED OR ENDORSED
BY, ANY BANK. THE SHARES ARE NOT FEDERALLY INSURED BY THE FEDERAL DEPOSIT
INSURANCE CORPORATION, THE FEDERAL RESERVE BOARD OR ANY OTHER GOVERNMENT
AGENCY. INVESTMENT IN THE SHARES INVOLVES RISK, INCLUDING POSSIBLE LOSS OF
PRINCIPAL.

Flag Investors Funds
P.O. Box 515
Baltimore, Maryland 21203

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THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION PASSED UPON
THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY
IS A CRIMINAL OFFENSE.

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<PAGE>

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FEE TABLE

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Shareholder Transaction Expenses:

<TABLE>
<S> <C>
Maximum Sales Charge Imposed on Purchases ................................... None
Maximum Sales Charge Imposed on Reinvested Dividends ........................ None
Maximum Deferred Sales Charge ............................................... None

Annual Fund Operating Expenses (as a percentage of average daily net assets):

Management Fees ............................................................. 0.70%
12b-1 Fees .................................................................. None
Other Expenses .............................................................. 0.16%
----
Total Fund Operating Expenses ............................................... 0.86%
====
</TABLE>

<TABLE>
<S> <C> <C>
Example: 1 year 3 years
- -------- ------ -------
You would pay the following expenses on a $1,000 invest-
ment, assuming (1) 5% annual return and (2) redemption at
the end of each time period: .............................. $9 $27
</TABLE>

The Expenses and Example should not be considered a representation of future
expenses. Actual expenses may be greater or less than those shown.

The purpose of the above table is to describe the various costs and
expenses that you will bear indirectly when you invest in Institutional Shares.
If you purchase Institutional Shares through a financial institution, you may
be charged separate fees by that institution. The Expenses and Example for the
Institutional Shares, which have not been offered prior to the date of this
Prospectus, are based on the Fund's expenses for the Class A Shares, another
class of shares offered by the Fund, less the 12b-1 fees charged to that class.
The Expenses and Example have been restated to reflect current fees.

1
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<PAGE>

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FINANCIAL HIGHLIGHTS
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The Fund has not offered the Institutional Shares prior to the date of
this Prospectus. However, the Fund has offered Class A Shares since January 18,
1984. Historical financial information is not fully applicable to the
Institutional Shares because the expenses paid by the Fund in the past differ
from those the Institutional Shares will incur. (See "Fee Table.")
Nevertheless, historical information about the Fund may be useful to investors
if they take into account the differences in expenses. Accordingly, the
financial highlights included in the following table are a part of the Fund's
financial statements for the Class A Shares for the periods indicated and have
been audited by Coopers & Lybrand L.L.P., independent accountants. The
financial statements and financial highlights for the Class A Shares for the
year ended December 31, 1996 and the report thereon of Coopers & Lybrand L.L.P.
are included in the Statement of Additional Information. Additional performance
information for the Class A Shares is contained in the Fund's Annual Report for
the fiscal year ended December 31, 1996, which can be obtained at no charge by
calling the Fund at (800) 767-FLAG.

(For a share outstanding throughout each year)
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<TABLE>
<CAPTION>
Class A Shares
-------------------------------------------------------
1996 1995 1994
----------------- ---------------- ----------------
<S> <C> <C> <C>
Per Share Operating Performance:
Net asset value at beginning of year ........................... $ 14.87 $ 12.30 $ 13.70
------- -------- --------

Income from Investment Operations:
Net investment income .......................................... 0.27 0.40 0.41
Net realized and unrealized gain/(loss) on investments ......... 1.67 3.58 ( 1.27)
------- -------- --------
Total from Investment Operations ............................... 1.94 3.98 ( 0.86)
------- -------- --------

Less Distributions:
Dividends from net investment income and net
realized short-term gains .................................... ( 0.38) ( 0.41) ( 0.44)
Distributions from net realized long-term gains ................ ( 0.84) ( 1.00) ( 0.10)
------- -------- --------
Total distributions ............................................ ( 1.22) ( 1.41) ( 0.54)
------- -------- --------
Net asset value at end of year ................................. $ 15.59 $ 14.87 $ 12.30
======= ======== ========
Total Return(3) ................................................. 13.46% 33.44% ( 6.32)%
Ratios to Average Daily Net Assets:
Expenses ....................................................... 1.14% 0.93%(4) 0.92%(4)
Net investment income .......................................... 1.74% 2.85%(5) 3.14%(5)

Supplemental Data:
Net assets at end of year (000) ................................ $ 505,371 $492,454 $435,805
Portfolio turnover rate ........................................ 20% 24% 23%
Average commissions per share .................................. $ 0.0696(6) -- --
</TABLE>
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(1) Restated for two-for-one stock split, effected in the form of a stock
dividend to shareholders of record on October 27, 1989.
(2) Investment Company Capital Corp. became Investment Advisor to the Fund on
January 19, 1989.
(3) Total return excludes the effect of sales charge.
(4) Without the waiver of advisory fees, the ratio of expenses to average daily
net assets would have been .99%, .99%, .98%, 1.07%, 1.17%, 1.13% and 1.07%
for the years ended December 31, 1995, 1994, 1993, 1992, 1991, 1990 and
1989, respectively.
(5) Without the waiver of advisory fees, the ratio of net investment income to
average daily net assets would have been 2.79%, 3.07%, 3.06%, 3.66%,
4.13%, 4.32% and 4.28% for the years ended December 31, 1995, 1994, 1993,
1992, 1991, 1990 and 1989, respectively.
(6) Disclosure is required for fiscal years beginning after September 1, 1995.
Represents average commission rate per share charged to the Fund on
purchases and sales of investments during the period.

2
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<PAGE>

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FINANCIAL HIGHLIGHTS(concluded)
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<TABLE>
<CAPTION>
Class A Shares
-----------------------------------
For the Year Ended December 31,
-----------------------------------
1993 1992 1991 1990 1989(1)(2) 1988(1) 1987(1)
- ----------------- ---------------- ---------------- ---------------- ---------------- ------------ -----------

<S> <C> <C> <C> <C> <C> <C>
$ 12.20 $ 11.28 $ 9.57 $ 10.98 $ 8.24 $ 7.50 $ 7.84
--------- -------- -------- -------- -------- ------- -------

0.42 0.42 0.45 0.46 0.52 0.46 0.43
1.78 0.93 1.74 ( 1.29) 3.38 0.97 ( 0.30)
--------- -------- -------- -------- -------- ------- -------
2.20 1.35 2.19 ( 0.83) 3.90 1.43 0.13
--------- -------- -------- -------- -------- ------- -------

(0.42) ( 0.42) ( 0.46) ( 0.45) ( 0.52) ( 0.46) ( 0.42)
(0.28) ( 0.01) ( 0.02) ( 0.13) ( 0.64) ( 0.23) ( 0.05)
--------- -------- -------- -------- -------- ------- -------
(0.70) ( 0.43) ( 0.48) ( 0.58) ( 1.16) ( 0.69) ( 0.47)
--------- -------- -------- -------- -------- ------- -------
$ 13.70 $ 12.20 $ 11.28 $ 9.57 $ 10.98 $ 8.24 $ 7.50
========= ======== ======== ======== ======== ======== =======
18.12% 12.35% 23.08% ( 7.55)% 48.86% 19.90% 1.51%

0.92%(4) 0.92%(4) 0.92%(4) 0.92%(4) 0.93%(4) 0.92% 0.88%
3.12%(5) 3.81%(5) 4.38%(5) 4.54%(5) 4.41%(5) 5.35% 5.37%

$ 469,163 $307,641 $238,571 $177,963 $162,449 $102,483 $94,650
14% 6% 7% 2% 27% 11% 4%
-- -- -- -- -- -- --
</TABLE>

3
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<PAGE>

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INVESTMENT PROGRAM
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Investment Objective, Policies and Risk
Considerations

The Fund's investment objective is to seek current income and long-term
growth of capital without undue risk. In seeking this objective, the Fund
invests primarily in common stock, securities convertible thereto and debt
obligations of companies in the telephone industry and in income-producing
securities (including debt obligations) of issuers in the telephone or other
industries. There can be no assurance that the Fund's investment objective will
be met. The Fund's investment objective may be changed only by the affirmative
vote of a majority of the outstanding shares of the Fund. Concentration in the
telephone industry will subject the Fund to the risks associated with that
industry (e.g., regulatory and technological change) and may result in greater
fluctuation in the Fund's net asset value than is experienced in less
concentrated portfolios. In light of the relatively limited number of telephone
companies, the Fund will be non-diversified for purposes of the Investment
Company Act of 1940 (the "Investment Company Act").

The Fund's investment advisors believe that investing in a portfolio of
securities of companies in the telephone industry affords an attractive
opportunity for achieving the Fund's investment objective. The telephone
industry comprises many well-capitalized companies that have demonstrated
stable, profitable growth. Significant technological and regulatory changes
have for some time been stimulating new services while certain unit costs are
declining. Extensive changes in telecommunications law, which became effective
on February 29, 1996, are likely to stimulate further rapid changes in the
telephone industry, as well as the telecommunications industry generally. The
new legislation will allow existing telephone companies, both local and
long-distance, to expand into each other's business as well as into other
telecommunications businesses, but will also permit other telecommunications
firms to enter the telephone business. In addition, the legislation enlarges
the scope of permitted affiliations between traditional telephone companies and
other telecommunications companies. The Fund's investment advisors believe that
because the telephone industry is a focal point in the development of the
information age, both for personal and for data communications, it provides new
opportunities for earnings and dividend growth. At the same time, these
developments pose challenges to companies in the telecommunications industry
with attendant risks.

Under normal market conditions at least 65% of the Fund's total assets
will be invested in common stock, securities convertible thereto and debt
obligations of companies in the telephone industry and at least 65% of the
<PAGE>

Fund's total assets will be invested in income-producing securities (including
debt obligations) of issuers in the telephone or other industries. The Fund may
purchase American Depositary Receipts ("ADRs"), which are U.S. exchange listed
interests in securities of foreign companies. ADRs include American Depositary
Shares and New York Shares and may be "sponsored" or "unsponsored." Sponsored
ADRs are established jointly by a depositary (typically a U.S. financial
institution) and the underlying issuer, whereas unsponsored ADRs may be
established by a depositary without participation by the underlying issuer.
Depending on the circumstances, the Fund may temporarily and for defensive
purposes invest up to 100% of its net assets in money market instruments and in
other income-producing securities.

In general, the Fund will invest in investment grade debt obligations
that are rated, at the time of purchase, BBB or higher by Standard and Poor's
Ratings Group ("S&P") or Baa or higher by Moody's Investors Service, Inc.
("Moody's"), or, if unrated, determined to be of comparable quality by the
Fund's investment advisors, under criteria approved by the Fund's Board of
Directors. Investment grade securities (securities rated BBB or higher by S&P
or Baa or higher by Moody's) are generally thought to provide the highest
credit quality and the smallest risk of default. Securities rated BBB by S&P or
Baa by Moody's have speculative characteristics. Up to 10% of the Fund's total
assets (measured at the time of the investment) may be invested in lower
quality debt obligations (securities rated BB or lower by S&P or Ba or lower by
Moody's and unrated securities of comparable quality). Securities that were
investment grade at the time of purchase but are subsequently downgraded to
BB/Ba or lower will be included in the 10% category. In the event any security
owned by the Fund is downgraded, the Fund's investment advisors will review the
situation and take appropriate action, but will not be automatically required
to sell any such security. If such a downgrade causes the 10% limit to be
exceeded, the Fund will be precluded from investing further in debt obligations
that are below investment grade. (See "Investments in Non-Investment Grade
Securities" below.)

Investments in Non-Investment Grade Securities

Lower rated debt obligations, also known as "junk bonds," are considered
to be speculative and involve greater risk of default or price changes due to
changes in the issuer's creditworthiness. Securities in the lowest rating
category that the Fund may purchase (secu-

4
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<PAGE>

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rities rated C by either S&P or Moody's) may present a particular risk of
default, or may be in default or arrears in the payment of principal and
interest. In addition, C-rated securities may be regarded as having extremely
poor prospects of ever attaining any real investment standing. Yields and
market values of these bonds will fluctuate over time reflecting changing
interest rates and the market's perception of credit quality and the outlook
for economic growth. When economic conditions appear to be deteriorating, lower
rated bonds may decline in value, regardless of prevailing interest rates.
Accordingly, adverse economic developments, including a recession or
substantial period of rising interest rates, may disrupt the high-yield bond
market, affecting both the value and liquidity of such bonds. The market prices
of these securities may fluctuate more than those of higher rated securities,
and may decline significantly in periods of general economic difficulty, which
may follow periods of rising interest rates. An economic downturn could
adversely affect the ability of issuers of such bonds to make payments of
principal and interest to a greater extent than issuers of higher rated bonds
might be affected. As of the date of this Prospectus, the Fund has not invested
in securities rated CCC or below. The ratings categories of S&P and Moody's are
described more fully in the Appendix to the Statement of Additional
Information.

The following table provides a summary of ratings assigned by S&P to debt
obligations in the Fund's portfolio. These figures are dollar-weighted averages
of month-end portfolio holdings during the fiscal year ended December 31, 1996,
presented as a percentage of total investments. These percentages are
historical and are not necessarily indicative of the quality of current or
future portfolio holdings, which may vary.

S&P
Rating Average
------ -------
AAA 1.60%
AA 0.00%
A 0.16%
BBB 0.00%
BB 0.92%
B 0.00%
Unrated 0.00%

Investments in Repurchase Agreements

The Fund may agree to purchase U.S. Government securities from
creditworthy financial institutions, such as banks or broker-dealers, subject
to the seller's agreement to repurchase the securities at an established time
and price. Default by or bankruptcy proceedings with respect to the seller may,
however, expose the Fund to possible loss because of adverse market action or
delay in connection with the disposition of the underlying obligations.

Other Investments

The Fund has the right to lend portfolio securities to recognized
institutional borrowers on a fully collateralized basis. To date, the Fund has
not lent portfolio securities. The Fund may also write covered call options if
each such option is traded on a national securities exchange (and may purchase
calls in related closing transactions). The Fund may also invest in securities
eligible for resale pursuant to Rule 144A under the Securities Act of 1933, as
amended ("Rule 144A Securities") that have been determined to be liquid by the
Fund's advisors under standards approved by the Fund's Board of Directors, and
may invest up to 10% of its net assets in Rule 144A Securities that are
illiquid (see "Investment Restrictions" in the Statement of Additional
Information). Rule 144A Securities may become illiquid if qualified
institutional buyers are not interested in acquiring the securities.

<PAGE>

INVESTMENT RESTRICTIONS
- --------------------------------------------------------------------------------

The following investment restrictions are matters of fundamental policy
and may not be changed without shareholder approval. Accordingly, the Fund will
not:

1) Invest less than 65% of the value of its total assets in the telephone
industry, except as described in this Prospectus (otherwise the Fund will
not concentrate more than 25% of its total assets in securities of issuers
in any industry); or

2) Invest in the securities of any single issuer if, as a result, the Fund
would hold more than 10% of the outstanding voting securities of such
issuer.

The Fund is subject to further investment restrictions that are set forth
in the Statement of Additional Information.

5
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<PAGE>

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HOW TO INVEST IN INSTITUTIONAL SHARES

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You may purchase Institutional Shares if you are either of the following:

1. An eligible institution (e.g., a financial institution, corporation,
investment counselor, qualified retirement plan, trust, estate or
educational, religious or charitable institution). If you are a
qualified retirement plan, your initial investment must be at least
$1,000,000. If you are any of the other institutions listed, your
initial investment must be at least $500,000. You may purchase
Institutional Shares through your securities dealer or through any
financial institution that is authorized to service shareholder
accounts ("Shareholder Servicing Agents"). You may also purchase
Institutional Shares by completing the attached Application Form and
returning it, together with payment of the purchase price, as
instructed.

2. A client of an investment advisory affiliate of BT Alex. Brown
purchasing shares in your investment advisory account. Your initial
or subsequent investments may be in any amount. Your investment
advisor will assist you in purchasing Institutional Shares.

You may purchase Institutional Shares on any day on which the New York
Stock Exchange is open for business (a "Business Day"). Your purchase order
will be executed at a per share purchase price equal to the net asset value
next determined after it is received. Purchases made through your securities
dealer or Shareholder Servicing Agent must be in accordance with their payment
procedures.

Your purchase order may not be accepted if the sale of Fund shares has
been suspended or if it is determined that your purchase would be detrimental
to the interests of the Fund's shareholders.

The net asset value per share is determined daily as of the close of the
New York Stock Exchange, which is ordinarily 4:00 p.m. (Eastern Time), on each
Busi-

<PAGE>

ness Day. Net asset value per share of a class is calculated by valuing
its share of the Fund's assets, deducting all liabilities attributable to that
class, and dividing the resulting amount by the number of then outstanding
shares of the class. For this purpose, portfolio securities will be given their
market value which is normally based on current prices but which may be
determined according to "fair value" procedures approved by the Fund's Board of
Directors.

Purchases by Exchange

You may exchange Institutional shares of other Flag Investors funds that
you own for an equal dollar amount of Institutional Shares of the Fund by
notifying the Fund's transfer agent (the "Transfer Agent") by telephone on any
Business Day between the hours of 8:30 a.m. and 5:30 p.m. (Eastern Time) (see
"Telephone Transactions" below) or by regular or express mail at the address
listed on page 12 of this Prospectus. If your shares are held in an account
with your securities dealer, Shareholder Servicing Agent or investment advisor,
ask them to effect the exchange for you.

The net asset value of Institutional Shares purchased and redeemed in an
exchange request received on the same Business Day will be determined on that
day, provided that the exchange request is received prior to 4:00 p.m. (Eastern
Time) or the close of the New York Stock Exchange, whichever is earlier.
Exchange requests received after 4:00 p.m. (Eastern Time) will be effected on
the next Business Day.

The Fund may modify or terminate this offer of exchange at any time on 60
days' prior written notice to shareholders.

Other Information

In the interest of economy and convenience and because of the operating
procedures for the Institutional Shares, certificates representing such shares
will not be issued.

6
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<PAGE>

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HOW TO REDEEM INSTITUTIONAL SHARES

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You may redeem all or part of your investment on any Business Day by
transmitting a redemption order through your securities dealer, your
Shareholder Servicing Agent or the Transfer Agent. You may also redeem your
shares by telephone (in amounts up to $500,000). (See "Telephone Transactions"
below.) A redemption order is effected at the net asset value per share next
determined after receipt of your order in proper form. Redemption orders
received after 4:00 p.m. (Eastern Time) or the close of the New York Stock
Exchange, whichever is earlier, will be effected at the net asset value next
determined on the following Business Day. You will be paid for redeemed
Institutional Shares by wire transfer of funds to your securities dealer,
Shareholder Servicing Agent or bank, upon receipt of a duly authorized
redemption request as promptly as feasible and, under most circumstances,
within three Business Days.

Dividends payable up to the date of redemption of Institutional Shares
will be paid on the next dividend payable date. If all of the shares in your
account have been redeemed on a dividend payable date, the dividend will be
remitted by wire to your securities dealer, Shareholder Servicing Agent or
bank.

The Fund has the power, under its Articles of Incorporation, to redeem
your account upon 60 days' notice if its value falls below $500 due to your
redemptions.

TELEPHONE TRANSACTIONS
- --------------------------------------------------------------------------------

You may redeem Institutional Shares in amounts up to $500,000, or
exchange Institutional shares of other Flag Investors funds in any amount by
notifying the Transfer Agent by telephone on any Business Day between the hours
of 8:30 a.m. and 5:30 p.m. (Eastern Time). If your shares are held in an
account with your securities dealer, Shareholder Servicing Agent or investment
advisor, ask them to effect your transaction. Telephone transaction privileges
are automatic unless you specifically request that no telephone redemptions or
exchanges be accepted for your account. This election may be made on the
Application Form or at any time thereafter by completing and returning
appropriate documentation supplied by the Transfer Agent.

A telephone exchange or redemption placed by 4:00 p.m. (Eastern Time) or
the close of the New York Stock Exchange, whichever is earlier, is effective
that day. Telephone orders placed after 4:00 p.m. (Eastern Time) will be
effected at the net asset value next determined on the following Business Day.

The Fund and the Transfer Agent will employ reasonable procedures to
confirm that instructions communicated by telephone are genuine. These
procedures include requiring you to provide certain personal identification
information at the time your account is opened and prior to effecting each
transaction requested by telephone. You may be required to provide additional
telecopied instructions. If these procedures are employed, neither the Fund nor
the Transfer Agent will be responsible for any loss, liability, cost or expense
for following instructions received by telephone that either of them reasonably
believes to be genuine. Your telephone transaction requests will be recorded.

During periods of extreme economic or market changes, you may experience
difficulty in effecting telephone transactions. In such event, requests should
be made by express mail or facsimile. (See "How to Invest in Institutional
Shares -- Purchases by Exchange" and "How to Redeem Institutional Shares.")
<PAGE>

DIVIDENDS AND TAXES
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Dividends and Distributions

The Fund's policy is to distribute to shareholders substantially all of
its taxable net investment income in the form of quarterly dividends. The Fund
will attempt to pay dividends that are consistent in amount with its taxable
net investment company income and reserves the right, with the approval of the
Directors, to pay dividends that constitute a return of capital which could
cause a decrease in a shareholder's tax basis in shares. The Fund normally will
distribute to shareholders any net capital gains on an annual basis.

Unless you elect otherwise, all income dividends and net capital gains
distributions will be reinvested in additional Institutional Shares at net
asset value. You may elect to terminate automatic reinvestment by giving
written notice to the Transfer Agent at the address

7
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<PAGE>

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listed on page 12 of this Prospectus, either directly or through your
securities dealer or Shareholder Servicing Agent, at least five days before the
next date on which dividends or distributions will be paid.

Tax Treatment of Dividends and Distributions

The following summary of certain federal income tax consequences
affecting the Fund and its shareholders is based on current tax laws and
regulations, which may be changed by legislative, judicial, or administrative
action. No attempt has been made to present a detailed explanation of the
federal, state or local tax treatment of the Fund or the shareholders, and the
discussion here is not intended as a substitute for careful tax planning.
Accordingly, you are urged to consult with your tax advisor regarding any
specific questions.

The Statement of Additional Information sets forth further information
concerning taxes.

The Fund has been and expects to continue to be taxed as a regulated
investment company under Subchapter M of the Internal Revenue Code of 1986, as
amended. As long as the Fund qualifies for this tax treatment, it will be
relieved of federal income tax on amounts distributed to shareholders. Unless
you are otherwise exempt, you will be generally subject to income tax on the
amounts distributed to you, regardless of whether such distributions are paid
to you in cash or reinvested in additional Institutional Shares.

You will be taxed on distributions from the Fund out of net capital gains
(the excess of net long-term capital gains over net short-term capital losses),
if any, as gains from the sale or exchange of a capital asset held for more
than one year regardless of the length of time you have held the Institutional
Shares. You will be taxed on all other income distributions as ordinary income.
If you are a corporate shareholder, you may be entitled to the dividends
received deduction on a portion of dividends received from the Fund. You will
be advised annually as to the federal income tax status of all distributions.

Ordinarily, you should include all dividends as income in the year of
payment. However, dividends declared payable to shareholders of record in
December of one year, but paid in January of the following year, will be deemed
for tax purposes to have been received by you and paid by the Fund in the year
in which the dividends were declared.

The Fund intends to make sufficient distributions of its ordinary income
and capital gain net income prior to the end of each calendar year to avoid
liability for federal excise tax.

The sale, exchange or redemption of Institutional Shares is a taxable
event for you.

<PAGE>

MANAGEMENT OF THE FUND
- --------------------------------------------------------------------------------

The overall business and affairs of the Fund are managed by its Board of
Directors. The Board approves all significant agreements between the Fund and
persons or companies furnishing services to the Fund, including the Fund's
agreements with its investment advisor, sub-advisor, distributor, custodian and
transfer agent. The day-to-day operations of the Fund are delegated to the
Fund's executive officers, to the Fund's investment advisors and its
distributor. A majority of the Directors are not affiliated with the Fund's
investment advisors or its distributor.

INVESTMENT ADVISOR AND SUB-ADVISOR
- --------------------------------------------------------------------------------

Investment Company Capital Corp. ("ICC" or the "Advisor") is the Fund's
investment advisor and Alex. Brown Investment Management ("ABIM" or the "Sub-
Advisor") is the Fund's sub-advisor. ICC is also the investment advisor to
other mutual funds in the Flag Investors family of funds and BT Alex. Brown
Cash Reserve Fund, Inc., which funds had approximately $6.1 billion of net
assets as of December 31, 1997. ABIM is a registered investment advisor with
approximately $7.2 billion under management as of December 31, 1997.

Pursuant to the terms of the Investment Advisory Agreement, ICC is
responsible for supervising and managing all of the Fund's operations. Under
the Investment Advisory and Sub-Advisory Agreements, ICC delegates to ABIM
certain of its duties, provided that ICC continues to supervise the performance
of ABIM and report thereon to the Fund's Board of Directors. Pursuant to the
terms of the Sub-Advisory Agreement, ABIM is responsible for decisions to buy
and sell securities for the Fund, for broker-dealer selection, and for
negotiation of commission rates under standards established and periodically
reviewed by the Board of Directors. The Board has established procedures under
which ABIM may allocate transactions to certain affiliates, provided that
compensation to such affiliates on each transaction is reasonable and fair
compared to the commission, fee or other remuneration received or to be
received by other broker-dealers in connection

8
- --------------------------------------------------------------------------------
<PAGE>

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

with comparable transactions involving similar securities during a comparable
period of time. In addition, consistent with NASD Rules, and subject to seeking
the most favorable price and execution available and such other policies as the
Board may determine, ABIM may consider services in connection with the sale of
shares as a factor in the selection of broker-dealers to execute portfolio
transactions for the Fund.

As compensation for providing investment advisory services to the Fund
for the fiscal year ended December 31, 1996, ICC received a fee equal to 0.66%
of the Fund's average daily net assets and from such fee paid ABIM a
sub-advisory fee equal to 0.45% of the Fund's average daily net assets. ICC may
from time to time voluntarily waive a portion of its fee to improve
performance.

ICC is an indirect subsidiary of Bankers Trust New York Corporation. ABIM
is a limited partnership affiliated with the Advisor. Buppert, Behrens & Owen,
Inc., a company organized and owned by three employees of ABIM, owns a 49%
limited partnership interest and a 1% general partnership interest in ABIM. BT
Alex. Brown owns a 1% general partnership interest in ABIM and BT Alex. Brown
Holdings, Inc. owns the remaining 49% limited partnership interest.

ICC also serves as the Fund's transfer and dividend disbursing agent and
provides accounting services to the Fund. An affiliate of ICC serves as the
Fund's custodian. (See "Custodian, Transfer Agent and Accounting Services.")

Portfolio Managers

Messrs. Bruce E. Behrens and Liam D. Burke have shared primary
responsibility for managing the Fund's assets since May 1, 1997. From the
Fund's inception through April 30, 1997, Mr. Behrens shared that responsibility
with Hobart C. Buppert, II, who remains at ABIM.

Bruce E. Behrens -- 29 Years' Investment Experience

Mr. Behrens has been a Vice President and a Principal of ABIM since 1981.
Prior to joining ABIM, Mr. Behrens was a Senior Vice President and Principal of
Corbyn Associates from 1978 to 1981 and a Vice President at Investment
Counselors of Maryland from 1972 to 1978. Prior thereto, he was a Securities
Analyst at Citibank from 1968 to 1972. Mr. Behrens received his B.A. from
Denison University in 1966 and an M.B.A. from the University of Michigan in
1968. He is a member and past President of the Baltimore Security Analysts
Society and a member of the Financial Analysts Federation.

Liam D. Burke -- 8 Years' Investment Experience

Mr. Burke joined ABIM in 1994 with primary responsibility as a
telecommunications analyst for the Fund. Prior to joining ABIM, Mr. Burke
worked as a telecommunications industry analyst at a regional broker-dealer,
Ferris, Baker, Watts, Inc., from 1992 to 1994 and as managing director of Frey
& Co., a Baltimore-based private investment bank, from 1989 to 1992. Mr. Burke
began his professional career at AT&T and spent eight years in positions that
included operations, regional staff management and national account sales. He
is a graduate of Georgetown University and received his MBA from The George
Washington University.
<PAGE>

DISTRIBUTOR
- --------------------------------------------------------------------------------

ICC Distributors, Inc. ("ICC Distributors" or the "Distributor") serves
as distributor of each class of the Fund's shares. ICC Distributors receives no
compensation for distributing the Institutional Shares. ICC Distributors is a
registered broker-dealer that offers distribution services to a variety of
registered investment companies including other funds in the Flag Investors
family of funds and BT Alex. Brown Cash Reserve Fund, Inc. ICC Distributors is
not affiliated with either the Advisor or the Sub-Advisor.

ICC Distributors bears all expenses associated with advertisements,
promotional materials, sales literature and printing and mailing prospectuses
to other than Fund shareholders. The Advisor or its affiliates may make
payments from their own resources to securities dealers and Shareholder
Servicing Agents.

9
- --------------------------------------------------------------------------------
<PAGE>

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

CUSTODIAN, TRANSFER AGENT AND ACCOUNTING SERVICES
- --------------------------------------------------------------------------------

Investment Company Capital Corp. is the Fund's transfer and dividend
disbursing agent and provides accounting services to the Fund. As compensation
for providing accounting services to the Fund for the fiscal year ended
December 31, 1996, ICC received a fee equal to 0.02% of the Fund's average
daily net assets. Bankers Trust Company, a subsidiary of Bankers Trust New York
Corporation, acts as custodian of the Fund's assets. (See the Statement of
Additional Information.)

PERFORMANCE INFORMATION
- --------------------------------------------------------------------------------

From time to time, the Fund may advertise its performance, including
comparisons to other mutual funds with similar investment objectives and to
stock or other relevant indices. All such advertisements will show the average
annual total return over one-, five- and ten-year periods or, if such periods
have not yet elapsed, shorter periods corresponding to the life of the Fund.
Such total return quotations will be computed by finding the average annual
compounded rates of return over such periods that would equate an assumed
initial investment of $1,000 to the ending redeemable value according to the
required standardized calculation. The standardized calculation is required by
the SEC to provide consistency and comparability in investment company
advertising and is not equivalent to a yield calculation. If the Fund compares
its performance to other funds or to relevant indices, the Fund's performance
will be stated in the same terms in which such comparative data and indices are
stated, which is normally total return rather than yield. For these purposes,
the performance of the Fund, as well as the performance of such investment
companies or indices, may not reflect sales charges, which, if reflected, would
reduce performance results.

The performance of the Fund may be compared to data prepared by Lipper
Analytical Services, Inc., CDA Investment Technologies, Inc. and Morningstar,
Inc., independent services that monitor the performance of mutual funds. The
performance of the Fund may also be compared to the Lehman Brothers Government
Corporate Bond Index, the Consumer Price Index, the return on 90-day U.S.
Treasury bills, the Standard & Poor's 500 Stock Index and the Dow Jones
Industrial Average. The Fund may also use total return performance data as
reported in the following national financial and industry publications that
monitor the performance of mutual funds: Money Magazine, Forbes, Business Week,
Barrons, Investor's Daily, IBC/Donoghue's Money Fund Report and The Wall Street
Journal.

Performance will fluctuate, and any statement of performance should not
be considered as representative of the future performance of the Fund.
Performance is generally a function of the type and quality of instruments held
by the Fund, operating expenses and market conditions. Any fees charged by your
bank with respect to accounts through which your Institutional Shares may be
purchased, although not included in calculations of performance, will reduce
your performance results.
<PAGE>

GENERAL INFORMATION
- --------------------------------------------------------------------------------
Capital Shares

The Fund is an open-end non-diversified management investment company.
The Fund reorganized as a Maryland corporation on January 19, 1989 and is
authorized to issue 85 million shares of capital stock, with a par value of
$.001 per share. Shares of the Fund have equal rights with respect to voting.
Voting rights are not cumulative, so the holders of more than 50% of the
outstanding shares voting together for election of Directors may elect all the
members of the Board of Directors of the Fund. In the event of liquidation or
dissolution of the Fund, each share would be entitled to its portion of the
Fund's assets after all debts and expenses have been paid. The fiscal year-end
of the Fund is December 31.

The Board of Directors is authorized to establish additional "series" of
shares of capital stock, each of which would evidence interests in a separate
portfolio of securities, and separate classes of each series of the Fund. The
shares offered by this Prospectus have been designated: "Flag Investors
Telephone Income Fund

10
- --------------------------------------------------------------------------------
<PAGE>

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

Institutional Shares." The Board has no present intention of establishing any
additional series of the Fund but the Fund does have three other classes of
shares in addition to the shares offered hereby: "Flag Investors Telephone
Income Fund Class A Shares" and "Flag Investors Telephone Income Fund Class B
Shares," which are offered by a separate prospectus and "Flag Investors
Telephone Income Fund Class D Shares," which are not currently being offered.
Additional information concerning the Fund's Class A and Class B Shares may be
obtained by calling the Fund at (800) 767-FLAG. Different classes of the Fund
may be offered to certain investors and holders of such shares may be entitled
to certain exchange privileges not offered to Institutional Shares. All classes
of the Fund share a common investment objective, portfolio of investments and
advisory fee, but to the extent the classes have different distribution/service
fees or sales load structures, performance may differ.

Annual Meetings

Unless required by Maryland law, the Fund does not expect to hold annual
meetings of shareholders. Shareholders of the Fund retain the right, under
certain circumstances, to request that a meeting of shareholders be held for
the purpose of considering the removal of a Director from office, and if such
a request is made, the Fund will assist with shareholder communications in
connection with the meeting.

Reports

You will be furnished with semi-annual reports containing information
about the Fund and its operations, including a list of investments held in the
Fund's portfolio and financial statements. The annual financial statements are
audited by the Fund's independent accountants, Coopers & Lybrand L.L.P.

Shareholder Inquiries

If you have any questions concerning your Institutional Shares, you
should contact the Fund at (800) 767-FLAG, the Transfer Agent at (800)
553-8080, or your securities dealer or Shareholder Servicing Agent.

11
- --------------------------------------------------------------------------------

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND, INC.
(INSTITUTIONAL SHARES)
NEW ACCOUNT APPLICATION
- --------------------------------------------------------------------------------

Make check payable to "Flag Investors Telephone Income Fund, Inc." and mail with
this application to:
Flag Investors Funds
330 West 9th Street, First Floor
Kansas City, MO 64105
Attn: Flag Investors Telephone Income Fund, Inc.

For assistance in completing this application please call: 1-800-553-8080,
Monday through Friday, 8:30 a.m. to 5:30 p.m. (Eastern Time).

If you are paying by check, make check payable to "Flag Investors Telephone
Income Fund, Inc." and mail with this Application. If you are paying by wire,
see instructions below.
- --------------------------------------------------------------------------------
Your Account Registration (Please Print)

<TABLE>
<CAPTION>
<S> <C>
Name on Account Mailing Address

- --------------------------------------------------------- -------------------------------------------------------------
Name of Corporation, Trust or Partnership Name of Individual to Receive Correspondence

- --------------------------------------------------------- -------------------------------------------------------------
Tax ID Number Street
/ / Corporation / / Partnership / / Trust -------------------------------------------------------------
/ / Non-Profit or Charitable Organization / / Other______ City State Zip
If a Trust, please provide the following: ( )
-------------------------------------------------------------
Daytime Phone

- ------------------------------------------------------------------------------------------------------------------------------------
Date of Trust For the Benefit of

- ------------------------------------------------------------------------------------------------------------------------------------
Name of Trustees (If to be included in the Registration)
- ------------------------------------------------------------------------------------------------------------------------------------
</TABLE>

Initial Investment

The minimum initial purchase for the Institutional Shares of the Fund is
$500,000, except that the minimum initial purchase is $1,000,000 for qualified
retirement plans. There is no minimum for clients of investment advisory
affiliates of BT Alex. Brown Incorporated or for subsequent investments.

Indicate the amount to be invested and the method of payment:

____ A. By Mail: Enclosed is a check in the amount of $__________ payable to
Flag Investors Telephone Income Fund, Inc.

____ B. By Wire: A bank wire in the amount of $__________ has been sent
from_______________________________________ __________________________
Name of Bank Wire Control Number
Wire Instructions
Follow the instructions below to arrange for a wire transfer for initial
investment:
o Send completed Application by overnight carrier to Flag Investors
Funds at the address listed above.
o Call 1-800-553-8080 to obtain new investor's Fund account number.
o Wire payment of the purchase price to Investors Fiduciary Trust
Company ("IFTC"), as follows:
IFTC
a/c Flag Investors Funds
Acct. # 7519206
ABA # 1010-0362-1
Kansas City, Missouri 64105

Please include the following information in the wire:
o Flag Investors Telephone Income Fund, Inc. -- Institutional Shares
o The amount to be invested
o "For further credit to ________________________________."
(Investor's Fund Account Number)
- --------------------------------------------------------------------------------

<PAGE>

Distribution Options

Please check appropriate boxes. If none of the options are selected, all
distributions will be reinvested in additional Institutional Shares of the
Fund.

Income Dividends Capital Gains
/ / Reinvested in additional shares / / Reinvested in additional shares
/ / Paid in cash / / Paid in cash
- --------------------------------------------------------------------------------
Telephone Transactions

I understand that I will automatically have telephone redemption privileges
(for amounts up to $500,000) and exchange privileges (with respect to
Institutional Shares of other Flag Investors Funds) unless I mark one or both
of the boxes below:
No, I do not want: / / Telephone redemption privileges
/ / Telephone exchange privileges
Redemptions effected by telephone will be wired to the bank account
designated below.
- --------------------------------------------------------------------------------
Bank Account Designation
(This Section Must Be Completed)

Please attach a blank, voided check to provide account and bank routing
information.

- --------------------------------------------------------------------------------
Name of Bank Branch

- --------------------------------------------------------------------------------
Bank Address City/State/Zip

- --------------------------------------------------------------------------------
Name(s) on Account

- --------------------------------------------------------------------------------
Account Number A.B.A. Number
A-1
<PAGE>

Acknowledgment, Certificate and Signature
- --------------------------------------------------------------------------------
The Fund may be required to withhold and remit to the U.S. Treasury 31% of any
taxable dividends, capital gains distributions and redemption proceeds paid to
any individual or certain other non-corporate shareholders who fail to provide
the information and/or certifications required below. This backup withholding
is not an additional tax, and any amounts withheld may be credited against the
shareholder's ultimate U.S. tax liability.

By signing this Application, I hereby certify under penalties of perjury that
the information on this Application is complete and correct and that as
required by federal law: (Please check applicable boxes)
/ / U.S. Citizen/Taxpayer:
/ / I certify that (1) the number shown above on this form is the correct
Tax ID Number and (2) I am not subject to any backup withholding
either because (a) I am exempt from backup withholding, or (b) I have
not been notified by the Internal Revenue Service ("IRS") that I am
subject to backup withholding as a result of a failure to report all
interest or dividends, or (c) the IRS has notified me that I am no
longer subject to backup withholding.
/ / If no Tax ID Number has been provided above, I have applied, or intend
to apply, to the IRS for a Tax ID Number, and I understand that if I
do not provide such number to the Transfer Agent within 60 days of the
date of this Application or if I fail to furnish my correct Tax ID
Number, I may be subject to a penalty and a 31% backup withholding on
distributions and redemption proceeds. (Please provide your Tax ID
Number on IRS Form W-9. You may request such form by calling the
Transfer Agent at 800-553-8080.)

/ / Non-U.S. Citizen/Taxpayer: Indicated country of residence for tax
purposes:__________________________________________________________________
Under penalties of perjury, I certify that I am not a U.S. citizen or
resident and I am an exempt foreign person as defined by the Internal
Revenue Service.
- --------------------------------------------------------------------------------

I have received a copy of the Fund's prospectus. I acknowledge that the
telephone redemption and exchange privileges are automatic and will be effected
as described in the Fund's current prospectus (see "Telephone Transactions"). I
also acknowledge that I may bear the risk of loss in the event of fraudulent
use of such privileges. If I do not want telephone redemption or exchange
privileges, I have so indicated on this Application.

- --------------------------------------------------------------------------------
The Internal Revenue Service does not require your consent to any provision of
this document other than the certifications required
to avoid backup withholding.
- --------------------------------------------------------------------------------

- --------------------------------------------------------------------------------
Signature of Corporate Officer, General Partner, Trustee, etc. Date

<PAGE>

Person(s) Authorized to Conduct Transactions

The following person(s) ("Authorized Person(s)") are currently officers,
trustees, general partners or other authorized agents of the investor.
Any ____________* of the Authorized Person(s) is, by lawful and appropriate
action of the investor, a person entitled to give instructions regarding
purchases and redemptions or make inquiries regarding the Account.

- ------------------------------------ ------------------------------------
Name/Title Signature Date

The signature appearing to the right of each Authorized Person is that person's
signature. Investment Company Capital Corp. ("ICC") may, without inquiry, act
upon the instructions (whether verbal, written, or provided by wire,
telecommunication, or any other process) of any person claiming to be an
Authorized Person. Neither ICC nor any entity on behalf of which ICC is acting
shall be liable for any claims or expenses (including legal fees) or for any
losses resulting from actions taken upon any instructions believed to be
genuine. ICC may continue to rely on the instructions made by any person
claiming to be an Authorized Person until it is informed through an amended
Application that the person is no longer an Authorized Person and it has a
reasonable period (not to exceed one week) to process the amended Application.
Provisions of this Application shall be equally Applicable to any successor of
ICC.
* If this space is left blank, any one Authorized Person is authorized to give
instructions and make inquiries. Verbal instructions will be accepted from
any one Authorized Person. Written instructions will require signatures of
the number of Authorized Persons indicated in this space.
- --------------------------------------------------------------------------------

<PAGE>

Certificate of Authority

Investors must complete one of the following two Certificates of Authority.

Certificate A: FOR CORPORATIONS AND UNINCORPORATED ASSOCIATIONS (With a Board
of Directors or Board of Trustees.)

I ________________, Secretary of the above-named investor, do hereby certify
that at a meeting on ___________________, at which a quorum was present
throughout, the Board of Directors (Board of Trustees) of the investor duly
adopted a resolution which is in full force and effect and in accordance with
the investor's charter and by-laws, which resolution did the following: (1)
empowered the officers/trustees executing this Application (or amendment) to
do so on behalf of the investor; (2) empowered the above-named Authorized
Person(s) to effect securities transactions for the investor on the terms
described above; (3) authorized the Secretary to certify, from time to time,
the names and titles of the officers of the investor and to notify ICC when
changes in officers occur; and (4) authorized the Secretary to certify that
such a resolution has been duly adopted and will remain in full force and
effect until ICC receives a duly-executed amendment to the Certification form.

Witness my hand and seal on behalf of the investor.

this______day of____________, 199__ Secretary_______________________________

The undersigned officer (other than the Secretary) hereby certifies that the
foregoing instrument has been signed by the Secretary of the investor.

- --------------------------------------------------------------------------------
Signature and title Date

Certificate B: FOR PARTNERSHIPS AND TRUSTS (Even if you are the sole trustee)

The undersigned certify that they are all general partners/trustees of the
investor and that they have done the following under the authority of the
investor's partnership agreement/trust instrument: (1) empowered the general
partner/trustee executing this Application (or amendment) to do so on behalf of
the investor; (2) empowered the above-named Authorized Person(s) to effect
securities transactions for the investor on the terms described above; (3)
authorized the Secretary to certify, from time to time, the names of the
general partners/trustees of the investor and to notify ICC when changes in
general partners/trustees occur. This authorization will remain in full force
and effect until ICC receives a further duly-executed certification. (If there
are not enough spaces here for all necessary signatures, complete a separate
certificate containing the language of this Certificate B and attach it to the
Application).

- --------------------------------------------------------------------------------
Signature and title Date

A-2
<PAGE>

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

FLAG INVESTORS TELEPHONE INCOME FUND, INC.

(Institutional Shares)

Investment Advisor
INVESTMENT COMPANY CAPITAL CORP.
One South Street
Baltimore, Maryland 21202

Sub-Advisor Distributor
ALEX. BROWN INVESTMENT MANAGEMENT ICC DISTRIBUTORS, INC.
One South Street P.O. Box 7558
Baltimore, Maryland 21202 Portland, Maine 04101

Transfer Agent Independent Accountants
INVESTMENT COMPANY CAPITAL CORP. COOPERS & LYBRAND L.L.P.
One South Street 2400 Eleven Penn Center
Baltimore, Maryland 21202 Philadelphia, Pennsylvania 19103
1-800-553-8080

Custodian Fund Counsel
BANKERS TRUST COMPANY MORGAN, LEWIS & BOCKIUS LLP
130 Liberty Street 2000 One Logan Square
New York, New York 10006 Philadelphia, Pennsylvania 19103

12
- --------------------------------------------------------------------------------

<PAGE>

STATEMENT OF ADDITIONAL INFORMATION

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

FLAG INVESTORS TELEPHONE INCOME FUND, INC.

One South Street
Baltimore, Maryland 21202

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

THIS STATEMENT OF ADDITIONAL INFORMATION IS NOT A
PROSPECTUS. IT SHOULD BE READ IN CONJUNCTION WITH
A PROSPECTUS, WHICH MAY BE OBTAINED FROM ANY
PARTICIPATING DEALER OR SHAREHOLDER SERVICING
AGENT OR BY WRITING OR CALLING THE FUND, ONE
SOUTH STREET, BALTIMORE, MARYLAND 21202, (800)
767-FLAG.

Statement of Additional Information Dated: May 1, 1997
as supplemented through February 25,1998
Relating to:
The Prospectus dated May 1, 1997 for the Flag Investors
Class A and Flag Investors Class B Shares and
The Prospectus dated February 25, 1998 for
Flag Investors Institutional Shares

<PAGE>

TABLE OF CONTENTS

Page

1. General Information and History............................... 1

2. Investment Objective and Policies............................. 2

3. Valuation of Shares and Redemption............................ 6

4. Federal Tax Treatment of Dividends and Distributions.......... 7

5. Management of the Fund........................................ 10

6. Investment Advisory and other Services........................ 15

7. Distribution of Fund Shares................................... 16

8. Brokerage..................................................... 20

9. Capital Stock................................................. 22

10. Semi-Annual Reports........................................... 23

11. Custodian, Transfer Agent and Accounting Services............. 23

12. Independent Accountants....................................... 24

13. Performance Information....................................... 24

14. Control Persons and Principal Holders of Securities........... 26

15. Financial Statements ............................... . . . . . 26

Appendix......................................................A-1

<PAGE>

1. GENERAL INFORMATION AND HISTORY

Flag Investors Telephone Income Fund, Inc. (the "Fund") is
an open-end management investment company that was originally designed to
provide both convenience and professional investment management to
shareholders of the former American Telephone and Telegraph Company ("AT&T")
after AT&T's divestiture and reorganization in January 1984.

Under the rules and regulations of the Securities and
Exchange Commission (the "SEC"), all mutual funds are required to furnish
prospective investors with certain information concerning the activities of
the company being considered for investment. The Fund currently offers three
classes of shares: Flag Investors Telephone Income Fund Class A Shares ("Class
A Shares"), Flag Investors Telephone Income Fund Class B Shares ("Class B
Shares") and Flag Investors Telephone Income Fund Institutional Shares
("Institutional Shares") (collectively, "Shares"). As used herein, the "Fund"
refers to Flag Investors Telephone Income Fund, Inc. and specific references
to any class of the Fund's shares will be made using the name of such class.
Important information concerning the Fund is included in the Fund's
Prospectuses which may be obtained without charge from the Fund's distributor
(the "Distributor") or from Participating Dealers that offer Shares to
prospective investors. Prospectuses may also be obtained from Shareholder
Servicing Agents. Some of the information required to be in this Statement of
Additional Information is also included in the Fund's current Prospectuses. To
avoid unnecessary repetition, references are made to related sections of the
Prospectuses. In addition, the Prospectuses and this Statement of Additional
Information omit certain information about the Fund and its business that is
contained in the Registration Statement for the Fund and its Shares filed with
the SEC. Copies of the Registration Statement as filed, including such omitted
items, may be obtained from the SEC by paying the charges prescribed under its
rules and regulations.

The Fund was organized as a Maryland corporation on October
18, 1983. Shares of the Fund were sold by the Distributor and other
broker-dealers in an offering that commenced on December 7, 1983. On January
18, 1984, the Fund effected a tax-free exchange of five of its Shares for each
share of AT&T common stock that had previously been transmitted to the Fund by
exchanging shareholders. The Fund collected the distributed shares of the
regional telephone companies created by AT&T's divestiture and undertook an
investment program consistent with the Fund's investment objectives. (See
Prospectus - "Investment Program"). On May 20, 1985, the Fund reorganized as a
Massachusetts business trust and on January 19, 1989, it reorganized as a
Maryland corporation pursuant to an Agreement and Plan of Reorganization and
Liquidation approved by shareholders on December 6, 1988.

For the period from April 6, 1993 through November 18, 1994,
the Fund offered another class of shares: Flag Investors Telephone Income Fund
Class D Shares, which were known at the time as Flag Investors Telephone
Income Fund Class B Shares and were reclassified as Flag Investors Telephone
Income Fund Class D Shares on November 18, 1994. Shares of that class are not
currently being offered although shares remain outstanding. The Fund commenced
offering the Flag Investors Telephone Income Fund Class B Shares on January 3,
1995. The Fund has not offered the Institutional Shares prior to the date of
this Statement of Additional Information.

Under a license agreement dated January 19, 1989 between the
Fund and Alex. Brown Incorporated, now BT Alex. Brown Incorporated, BT Alex.
Brown Incorporated licenses to the Fund the "Flag Investors" name and logo but
retains rights to that name and logo, including the right to permit other
investment companies to use them.

<PAGE>

2. INVESTMENT OBJECTIVE AND POLICIES

The Fund's investment objective is to seek current income
and long-term growth of capital without undue risk. In seeking this objective,
the Fund invests primarily in common stock, securities convertible thereto and
debt obligations of companies in the telephone industry and in
income-producing securities (including debt obligations) of issuers in the
telephone or other industries. The Fund's investment advisor (the "Advisor")
and sub-advisor (the "Sub-Advisor"), collectively, (the "Advisors"), believe
that investing in a portfolio of securities of companies in the telephone
industry affords an attractive opportunity for achieving this investment
objective. There can be no assurance, however, that the Fund's investment
objective will be achieved.

Depending on the circumstances, the Fund may temporarily and
for defensive purposes, invest up to 100% of its net assets in money market
instruments and in other income-producing securities. The Fund may also enter
into repurchase agreements, may loan portfolio securities, and may write
covered call options. In general, the Fund will invest in investment grade
debt obligations that are rated, at the time of purchase, BBB or higher by
Standard & Poor's Ratings Group ("S&P") or Baa or higher by Moody's Investors
Service, Inc. ("Moody's"). Up to 10% of the Fund's assets may be invested in
lower quality debt obligations (securities rated BB or lower by S&P or Ba or
lower by Moody's). (See "Below Investment Grade Securities" below.) The
ratings categories of S&P and Moody's are described more fully in Appendix A.

Below Investment Grade Securities

The Fund may purchase debt obligations that carry ratings
lower than those assigned to investment grade bonds by Moody's or S&P, or that
are unrated if such bonds, in the Advisors' judgment, meet the quality
criteria established by the Board of Directors. These bonds are generally
known as "junk bonds." These securities may trade at substantial discounts
from their face values. Accordingly, if the Fund is successful in meeting its
objectives, investors may receive a total return consisting not only of income
dividends but, to a lesser extent, capital gain distributions. Appendix A to
this Statement of Additional Information sets forth a description of the S&P
and Moody's rating categories, which indicate the rating agency's opinion as
to the probability of timely payment of interest and principal. These ratings
range in descending order of quality from AAA to D (though the Fund will not
purchase securities rated, at the time of purchase, below C), in the case of
S&P, and from Aaa to C, in the case of Moody's. Generally, securities that are
rated lower than BBB by S&P or Baa by Moody's are described as below
investment grade. Securities rated lower than investment grade may be of a
predominantly speculative character and their future cannot be considered
well-assured. The issuer's ability to make timely payments of principal and
interest may be subject to material contingencies. Securities in the lowest
rating categories may be unable to make timely interest or principal payments
and may be in default and in arrears in interest and principal payments.

Ratings of S&P and Moody's represent their opinions of the
quality of bonds and other debt securities they undertake to rate at the time
of issuance. However, these ratings are not absolute standards of quality and
may not reflect changes in an issuer's creditworthiness. Accordingly, the
Advisors do not rely exclusively on ratings issued by S&P or Moody's in
selecting portfolio securities but supplement such ratings with independent
and ongoing review of credit quality. In addition, the total return the Fund
may earn from investments in high-yield securities will be significantly
affected not only by credit quality but by fluctuations in the markets in
which such securities are traded. Accordingly, selection and supervision by
the Advisors of investments in lower rated securities involves continuous
analysis of individual issuers, general business conditions,

-2-

<PAGE>
activities in the high-yield bond market and other factors. The analysis of
issuers may include, among other things, historic and current financial
conditions, strength of management, responsiveness to business conditions,
credit standing and current and anticipated results of operations. Analysis of
general business conditions and other factors may include anticipated changes
in economic activity in interest rates, the availability of new investment
opportunities and the economic outlook for specific industries.

Investing in higher yield, lower rated bonds entails
substantially greater risk than investing in investment grade bonds, including
not only credit risk, but potentially greater market volatility and lower
liquidity. Yields and market values of high-yield bonds will fluctuate over
time, reflecting not only changing interest rates but the bond market's
perception of credit quality and the outlook for economic growth. When
economic conditions appear to be deteriorating, lower rated bonds may decline
in value due to heightened concern over credit quality, regardless of
prevailing interest rates. In adverse economic conditions, the liquidity of
the secondary market for junk bonds may be significantly reduced. In addition,
adverse economic developments could disrupt the high-yield market, affecting
both price and liquidity, and could also affect the ability of issuers to
repay principal and interest, thereby leading to a default rate higher than
has been the case historically. Even under normal conditions, the market for
junk bonds may be less liquid than the market for investment grade corporate
bonds. There are fewer securities dealers in the high-yield market and
purchasers of high-yield bonds are concentrated among a smaller group of
securities dealers and institutional investors. In periods of reduced market
liquidity, the market for junk bonds may become more volatile and there may be
significant disparities in the prices quoted for high-yield securities by
various dealers. Under conditions of increased volatility and reduced
liquidity, it would become more difficult for the Fund to value its portfolio
securities accurately because there might be less reliable, objective data
available.

Finally, prices for high-yield bonds may be affected by
legislative and regulatory developments. For example, from time to time,
Congress has considered legislation to restrict or eliminate the corporate tax
deduction for interest payments or to regulate corporate restructurings such
as takeovers, mergers or leveraged buyouts. Such legislation may significantly
depress the prices of outstanding high-yield bonds.

Repurchase Agreements

The Fund may enter into repurchase agreements with domestic
banks or broker-dealers deemed to be creditworthy by the Advisors, under
guidelines approved by the Board of Directors. A repurchase agreement is a
short-term investment in which the purchaser (i.e., the Fund) acquires
ownership of a debt security and the seller agrees to repurchase the
obligation at a future time and set price, usually not more than seven days
from the date of purchase, thereby determining the yield during the
purchaser's holding period. The value of underlying securities will be at
least equal at all times to the total amount of the repurchase obligation,
including the interest factor. The Fund makes payment for such securities only
upon physical delivery or evidence of book entry transfer to the account of a
custodian, sub-custodian, or bank acting as agent. The underlying securities,
which in the case of the Fund are securities of the U.S. Government only, may
have maturity dates exceeding one year. The Fund does not bear the risk of a
decline in value of the underlying securities unless the seller defaults under
its repurchase obligation. In the event of a bankruptcy or other default of a
seller of a repurchase agreement, the Fund could experience both delays in
liquidating the underlying securities and loss including: (a) possible decline
in the value of the underlying security during the period during which the
Fund seeks to enforce its rights thereto,

-3-

<PAGE>

(b) possible subnormal levels of income and lack of access to income during
this period, and (c) expenses of enforcing its rights.

Lending of Portfolio Securities

The Fund may lend portfolio securities to Board-approved
brokers or dealers in corporate or government securities, banks or other
recognized institutional borrowers of securities, provided that the borrower
maintains cash or equivalent collateral or a letter of credit in the Fund's
favor of not less than 100% of the market value of the securities loaned by
marking to market daily. While the portfolio securities are on loan, the Fund
receives from the borrower an amount equal to any dividend or interest paid on
such securities. The Fund may invest the cash collateral to generate
additional income or it may by agreement with the borrower receive interest
income from the borrower. Either the Fund or the borrower may terminate the
loan at any time. The Fund may pay reasonable administrative and custodial
fees in connection with a loan and may agree to pay a portion of interest
generated on the Fund's investment of the cash or equivalent collateral to the
borrower or placing broker. The Fund has no current intention of lending more
than 5% of its portfolio securities.

Covered Call Options

In an attempt to earn additional income, and as a means of
protecting the Fund's assets against market declines, the Fund may, to a
limited extent, write covered call option contracts on certain of its
securities and purchase call options for the purpose of terminating its
outstanding obligations with respect to securities upon which call option
contracts have been written.

When the Fund writes a call option on securities that it
owns, it gives the purchaser of the option the right to buy the securities at
the price specified in the option (the "Exercise Price") at any time prior to
the expiration of the option. In the strategy to be employed by the Fund, the
Exercise Price, plus the option premium paid by the purchaser, is almost
always greater than the market price of the underlying security at the time
the option is written. If any option is exercised, the Fund will realize the
long-term or short-term gain or loss from the sale of the underlying security
and the proceeds of the sale will be increased by the net premium originally
received. By writing a covered option, the Fund may forego, in exchange for
the net premium, the opportunity to profit from an increase in value of the
underlying security above the Exercise Price. Thus, options will be written
when the Advisors believe the security should be held for the long term but
expect no appreciation or only moderate appreciation within the option period.
The Fund also may write covered options on securities that have a current
value above the original purchase price but which, if then sold, would not
normally qualify for a long-term capital gains treatment. Such activities will
normally take place during periods when market volatility is expected to be
high.

Only call options that are traded on a national securities
exchange will be written. Call options are issued by the Options Clearing
Corporation, which also serves as the clearing house for transactions with
respect to options. The price of a call option is paid to the writer without
refund on expiration or exercise, and no portion of the price is retained by
The Options Clearing Corporation or the exchanges listed above. Writers and
purchasers of options pay the transaction costs, which may include commissions
charged or incurred in connection with such option transactions.

The Fund may write options contracts on its securities up to
an amount not in excess of 20% of the value of its net assets at the time such
options are written. The Fund will not

-4-

<PAGE>

sell the securities against which options have been written (uncover the
options) until after the option period has expired, the option has been
exercised or a closing purchase has been executed.

Call options may be purchased by the Fund, but only to
terminate an obligation as a writer of a call option. This is accomplished by
making a closing purchase transaction, that is, the purchase of a call option
on the same security with the same Exercise Price and expiration date as
specified in the call option that had been written previously. A closing
purchase transaction with respect to calls traded on a national securities
exchange has the effect of extinguishing the obligation of a writer. Although
the cost to the Fund of such a transaction may be greater than the net premium
received by the Fund upon writing the original option, the Directors believe
that it is appropriate for the Fund to have the ability to make closing
purchase transactions in order to prevent its portfolio securities from being
purchased pursuant to the exercise of a call. The Advisors may also permit the
call option to be exercised. A profit or loss from a closing purchase
transaction will be realized depending on whether the amount paid to purchase
a call to close a position is less or more than the amount received from
writing the call. A profit or loss from an option exercised will be realized
depending upon whether the cost of the stock sold through the exercise, minus
the premium received on the option, is less or more than the proceeds of the
exercise.

Investment Restrictions

The Fund's investment program is subject to a number of
investment restrictions which reflect self-imposed standards as well as
federal regulatory limitations. The investment restrictions recited below are
in addition to those described in the Fund's Prospectus, and are matters of
fundamental policy and may not be changed without the affirmative vote of a
majority of outstanding shares. The percentage limitations contained in these
restrictions apply at the time of purchase of securities. Accordingly, the
Fund will not:

1. Borrow money, except as a temporary measure for
extraordinary or emergency purposes and then only from banks and in an amount
not exceeding 10% of the value of the total assets of the Fund at the time of
such borrowing, provided that, while borrowings by the Fund equaling 5% or
more of the Fund's total assets are outstanding, the Fund will not purchase
securities for investment;

2. Invest in real estate or mortgages on real estate;

3. Purchase or sell commodities or commodities contracts;

4. Act as an underwriter of securities within the meaning of
the U.S. federal securities laws except insofar as it might be deemed to be an
underwriter upon disposition of certain portfolio securities acquired within
the limitation on purchases of restricted securities;

5. Issue senior securities;

6. Make loans, except that the Fund may purchase or hold
debt instruments in accordance with its investment objectives and policies,
and may loan portfolio securities and enter into repurchase agreements as
described in this Registration Statement;

7. Effect short sales of securities;

-5-

<PAGE>

8. Purchase securities on margin (but the Fund may obtain
such short-term credits as may be necessary for the clearance of
transactions);

9. Purchase participations or other interests in oil, gas or
other mineral exploration or development programs; or

10. Invest more than 10% of the value of its net assets in
illiquid securities (as defined under federal and state securities laws),
including repurchase agreements with remaining maturities in excess of seven
days.

The following investment restriction may be changed by a
vote of the majority of the Board of Directors. The Fund will not:

1. Invest in shares of any other investment company
registered under the Investment Company Act of 1940, except as permitted by
federal law.

3. VALUATION OF SHARES AND REDEMPTION

Valuation of Shares

The net asset value per Share is determined daily as of the
close of the New York Stock Exchange, which is ordinarily 4:00 p.m. (Eastern
Time) each day on which the New York Stock Exchange is open for business (a
"Business Day"). The New York Stock Exchange is open for business on all
weekdays except for the following holidays: New Year's Day, Martin Luther King
Jr.'s Birthday, Presidents' Day, Good Friday, Memorial Day, Independence Day,
Labor Day, Thanksgiving Day and Christmas Day.

The Fund may enter into agreements that allow a third party,
as agent for the Fund, to accept orders from its customers up until the Fund's
close of business which is ordinarily 4:00 p.m. (Eastern Time). Under such
agreements, so long as a third party receives an order prior to the Fund's
close of business, the order is deemed to have been received by the Fund and,
accordingly, may receive the net asset value computed at the close of business
that day. These "late day" agreements are intended to permit shareholders
placing orders with third parties to place orders up to the same time as other
shareholders.

Redemption

The Fund may suspend the right of redemption or postpone the
date of payment during any period when (a) trading on the New York Stock
Exchange is restricted by applicable rules and regulations of the SEC; (b) the
New York Stock Exchange is closed for other than customary weekend and holiday
closings; (c) the SEC has by order permitted such suspension; or (d) an
emergency exists as determined by the SEC so that valuation of the net assets
of the Fund is not reasonably practicable.

Under normal circumstances, the Fund will redeem Class A
Shares and Class B Shares by check and Institutional Shares by wire transfer
of funds as described in the related Prospectus. However, if the Board of
Directors determines that it would be in the best interests of the remaining
shareholders of the Fund to make payment of the redemption price in whole or
in part by a distribution in kind of readily marketable securities from the
portfolio of the Fund in lieu of cash,

-6-

<PAGE>

in conformity with applicable rules of the SEC, the Fund will make such
distributions in kind. If Shares are redeemed in kind, the redeeming
shareholder will incur brokerage costs in later converting the assets into
cash. The method of valuing portfolio securities is described in the
Prospectus under "How to Invest," and such valuation will be made as of the
same time the redemption price is determined. The Fund, however, has elected
to be governed by Rule 18f-1 under the Investment Company Act of 1940, as
amended (the "1940 Act") pursuant to which the Fund is obligated to redeem
Shares solely in cash up to the lesser of $250,000 or 1% of the net asset
value of the Fund during any 90-day period for any one shareholder.

4. FEDERAL TAX TREATMENT OF DIVIDENDS AND DISTRIBUTIONS

The following discussion of certain federal income tax
consequences is based on the Internal Revenue Code of 1986, as amended (the
"Code") and the regulations issued thereunder as in effect on the date of this
Statement of Additional Information. New legislation, as well as
administrative changes or court decisions, may significantly change the
conclusions expressed herein, and may have a retroactive effect with respect
to the transactions contemplated herein.

The following is only a summary of certain additional
federal income tax considerations generally affecting the Fund and its
shareholders that are not described in the Fund's Prospectus. No attempt is
made to present a detailed explanation of the tax treatment of the Fund or its
shareholders, and the discussion here and in the Fund's Prospectus is not
intended as a substitute for careful tax planning.

Qualification as a Regulated Investment Company

The Fund has elected to be, and intends to be, taxed as a
regulated investment company ("RIC") under Subchapter M of the Code. In order
to qualify as a RIC for any taxable year, the Fund must generally derive at
least 90% of its gross income from dividends, interest, certain payments with
respect to securities loans, and gains from the sale or other disposition of
stock, securities, or foreign currencies and other income (including, but not
limited to, gains from options, futures or forward contracts) derived with
respect to its business of investing in stocks, securities or currencies (the
"Income Requirement").

In addition, at the close of each quarter of the Fund's
taxable year, at least 50% of the value of its total assets must consist of
cash and cash items, U.S. government securities, securities of other RICs, and
securities of other issuers (as to which the Fund has not invested more than
5% of the value of its total assets in securities of any such issuer and as to
which the Fund does not hold more than 10% of the outstanding voting
securities of any such issuer), and no more than 25% of the value of its total
assets may be invested in the securities of any one issuer (other than U.S.
government securities and securities of other RICs), or in two or more issuers
that the Fund controls and that are engaged in the same, similar or related
trades or businesses (the "Asset Diversification Test"). The Fund will not
lose its status as a RIC if it fails to meet the Asset Diversification Test
solely as a result of a fluctuation in value of portfolio assets not
attributable to a purchase. The Fund may curtail its investments in certain
securities where the application thereto of the Asset Diversification Test is
uncertain.

Under Subchapter M, the Fund is exempt from federal income
tax on its net investment income and capital gains that it distributes to
shareholders, provided that it distributes at least 90% of its investment
company taxable income (net investment income and the excess of net

-7-

<PAGE>

short term capital gains over net long term capital losses) for the year (the
"Distribution Requirement") and complies with the other requirements of the
Code described above. The Distribution Requirement for any year may be waived
if a RIC establishes to the satisfaction of the Internal Revenue Service that
it is unable to satisfy the Distribution Requirement by reason of
distributions previously made for the purpose of avoiding liability for
federal excise tax.

Although the Fund intends to distribute substantially all of
its net investment income and capital gains for any taxable year, the Fund
will be subject to federal income taxation to the extent any such income or
gains are not distributed.

If for any taxable year, the Fund does not qualify as a
regulated investment company, all of its taxable income will be subject to tax
at regular corporate income tax rates without any deduction for distributions
to shareholders, and all such distributions generally will be taxable to
shareholders as ordinary dividends to the extent of the Fund's current and
accumulated earnings and profits. Such distributions generally will be
eligible for the 70% dividends received deduction for corporate shareholders.

Fund Distributions

Distributions of investment company taxable income will be
taxable to shareholders as ordinary income, regardless of whether such
distributions are paid in cash or are reinvested in additional Shares.

The Fund may either retain or distribute to shareholders its
excess of net long-term capital gains over net short-term capital losses ("net
capital gain") for each taxable year. If such gains are distributed as a
capital gains distribution, they are taxable to shareholders as gains from the
sale or exchange of a capital asset held for more than one year, regardless of
the length of time the shareholder has held the Shares, whether or not such
gains were recognized by the Fund prior to the date on which a shareholder
acquired the Shares and whether or not the distribution was paid in cash or
reinvested in Shares. In the unlikely event the Fund elects to retain its net
capital gains, it is expected that the Fund will elect to have shareholders
treated as having received a distribution of such gains, with the result that
shareholders will be required to report such gains on their returns as capital
gains, will receive a tax credit for their allocable share of capital gains
tax paid by the Fund on the gains, and will increase the tax basis for their
Shares by an amount equal to 65% of such gains.

Generally, gain or loss on the sale or exchange of a Share
will be a capital gain or loss which will be long-term if the Share has been
held for eighteen months or more, mid-term if the Share has been held for more
than twelve but less than eighteen months, and otherwise will be short-term.
However, a shareholder who realizes a loss on the sale, exchange or redemption
of a Share held for six months or less and has previously received a capital
gains distribution with respect to the Share (or has included in income any
undistributed net capital gains of the Fund with respect to such Share) must
treat the loss as a long-term capital loss to the extent of the amount of the
prior capital gains distribution (or any undistributed net capital gains of
the Fund with respect to such Share that have been included in the
shareholder's income). In addition, any loss realized on a sale or other
disposition of Shares will be disallowed to the extent an investor repurchases
(or enters into a contract or option to repurchase) Shares within a period of
61 days (beginning 30 days before and ending 30 days after the disposition of
the Shares). This loss disallowance rule will apply to Shares received through
the reinvestment of dividends during the 61-day period.

-8-

<PAGE>

Investors purchasing Shares just prior to an ordinary income
dividend or capital gains distribution will be taxable on the entire amount of
the dividend or distribution received, even though the net asset value per
Share on the date of such purchase may have reflected the amount of such
forthcoming dividend or distribution.

In the case of corporate shareholders, Fund distributions
(other than capital gains distributions) generally qualify for the 70%
dividends received deduction to the extent of the gross amount of certain
qualifying dividends received by the Fund for the year. Generally, a dividend
will be treated as a qualifying dividend if it has been received from a
domestic corporation. For purposes of the alternative minimum tax and the
environmental tax, corporate shareholders generally will be required to take
the full amount of any dividend received from the Fund into account in
determining their adjusted current earnings for purposes of computing
"alternative minimum taxable income."

The Fund will be required in certain cases to withhold and
remit to the United States Treasury 31% of distributions payable to any
shareholder who (1) has provided either an incorrect taxpayer identification
number or no number at all, (2) is subject to backup withholding by the
Service for failure to properly report the receipt of interest or dividend
income, or (3) has failed to certify to the Fund that such shareholder is not
subject to backup withholding.

The Fund will provide a statement annually to shareholders
as to the federal income tax status of distributions paid (or deemed to be
paid) by the Fund during the year.

Federal Excise Tax; Miscellaneous Considerations

The Code imposes a nondeductible 4% federal excise tax on
RICs that do not distribute in each calendar year an amount equal to 98% of
their ordinary income for the calendar year plus 98% of their capital gain net
income (the excess of long- and short-term capital gain over long- and
short-term capital loss) for the one-year period ending on October 31 of such
calendar year. The excise tax is imposed on the undistributed part of this
required distribution. In addition, the balance of such income must be
distributed during the next calendar year to avoid liability for the excise
tax in that year. For the foregoing purposes, an investment company is treated
as having distributed any amount on which it is subject to income tax for any
taxable year ending in such calendar year.

The Fund intends to make sufficient distributions of its
ordinary income and capital gain net income prior to the end of each calendar
year to avoid liability for excise tax. In certain circumstances the Fund may
be required to liquidate portfolio investments in order to make sufficient
distributions to avoid excise tax liability.

Rules of state and local taxation of dividend and capital
gains distributions from regulated investment companies often differ from the
rules for federal income taxation described above. Shareholders are urged to
consult their tax advisors as to the consequences of these and other state and
local tax rules affecting investment in the Fund.

-9-

<PAGE>

5. MANAGEMENT OF THE FUND

Directors and Officers

The Directors and executive officers of the Fund, their
respective dates of birth and their principal occupations during the last five
years are set forth below. Unless otherwise indicated, the address of each
Director and executive officer is One South Street, Baltimore, Maryland 21202.

*TRUMAN T. SEMANS, Chairman (10/27/26)
Managing Director Emeritus, BT Alex. Brown Incorporated; Formerly,
Vice Chairman, Alex. Brown Incorporated (now BT Alex. Brown
Incorporated); Vice Chairman Alex. Brown Capital Advisory & Trust
Company; and Director, Investment Company Capital Corp. (registered
investment advisor).

*RICHARD T. HALE, Director (7/17/45)
Managing Director, BT Alex. Brown Incorporated; Director and
President, Investment Company Capital Corp. (registered investment
advisor); Chartered Financial Analyst.

JAMES J. CUNNANE, Director (3/11/38)
CBC Capital, 264 Carlyle Lake Drive, St. Louis, Missouri 63141.
Managing Director, CBC Capital (merchant banking), 1993-Present;
Formerly, Senior Vice President and Chief Financial Officer, General
Dynamics Corporation (defense), 1989-1993 and Director, The Arch Fund
(registered investment company).

JOHN F. KROEGER, Director (8/11/24)
37 Pippins Way, Morristown, New Jersey 07960. Director/Trustee, AIM
Funds (registered investment companies); Formerly, Consultant,
Wendell & Stockel Associates, Inc. (consulting firm) and General
Manager, Shell Oil Company.

LOUIS E. LEVY, Director (11/16/32)
26 Farmstead Road, Short Hills, New Jersey 07078. Director,
Kimberly-Clark Corporation (personal consumer products) and Household
International (banking and finance); Chairman of the Quality Control
Inquiry Committee, American Institute of Certified Public
Accountants; Formerly, Trustee, Merrill Lynch Funds for Institutions,
1991-1993; Adjunct Professor, Columbia University-Graduate School of
Business, 1991-1992; Partner, KPMG Peat Marwick, retired 1990.

EUGENE J. MCDONALD, Director (7/14/32)
Duke Management Company, Erwin Square, Suite 1000, 2200 West Main
Street, Durham, North Carolina 27705. President, Duke Management
Company (investments); Executive Vice President, Duke University
(education, research and health care); Director, Central Carolina
Bank & Trust (banking), Key Funds (registered investment companies)
and DP Mann Holdings (insurance); Formerly, Director AMBAC Treasurers
Trust (registered investment company).

REBECCA W. RIMEL, Director (4/10/51)
The Pew Charitable Trusts, One Commerce Square, 2005 Market Street,
Suite 1700, Philadelphia, Pennsylvania 19103-7017; President and
Chief Executive Officer, The Pew Charitable Trusts; Director and
Executive Vice President, The Glenmede Trust Company; Formerly,
Executive Director, The Pew Charitable Trusts.

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<PAGE>

CARL W. VOGT, Esq., Director (4/20/36)
Fulbright & Jaworski L.L.P., 801 Pennsylvania Avenue, N.W.,
Washington, D.C. 20004- 2604. Senior Partner, Fulbright & Jaworski
L.L.P. (law); Director, Yellow Corporation (trucking) and American
Science & Engineering (x-ray detection equipment); Formerly, Chairman
and Member, National Transportation Safety Board; Director, National
Railroad Passenger Corporation (Amtrak) and Member, Aviation System
Capacity Advisory Committee (Federal Aviation Administration).

HARRY WOOLF, President (8/12/23)
Institute for Advanced Study, Olden Lane, Princeton, New Jersey
08540. Professor-at-Large Emeritus, Institute for Advanced Study;
Director, ATL and Spacelabs Medical Corp. (medical equipment) and
Family Health International (non-profit research and education);
Director, Research America (non-profit medical research); Formerly,
Director, Flag Investors/ISI/BT Alex. Brown Family of Funds; Trustee,
Rockefeller Foundation; Director, Merrill Lynch Cluster C Funds
(registered investment companies); and Trustee, Reed College
(education).

AMY M. OLMERT, Secretary (5/14/63)
Vice President, BT Alex. Brown Incorporated, June 1997-Present.
Formerly, Senior Manager, Coopers & Lybrand L.L.P., September 1988 -
June 1997.

JOSEPH A. FINELLI, Treasurer (1/24/57)
Vice President, BT Alex. Brown Incorporated and Vice President,
Investment Company Capital Corp. (registered investment advisor),
September 1995-Present; Formerly, Vice President and Treasurer, The
Delaware Group of Funds (registered investment companies) and Vice
President, Delaware Management Company, Inc. (investments),
1980-August 1995.

SCOTT J. LIOTTA, Assistant Secretary (3/18/65)
Assistant Vice President, BT Alex. Brown Incorporated, July
1996-Present; Formerly, Manager and Foreign Markets Specialist,
Putnam Investments Inc. (registered investment companies), April
1994-July 1996; Supervisor, Brown Brothers Harriman & Co. (domestic
and global custody), August 1991-April 1994.

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

* Messrs. Semans and Hale are directors who are "interested persons,"
as defined in the 1940 Act.
.

Directors and officers of the Fund are also directors and
officers of some or all of the other investment companies managed,
administered or advised by BT Alex. Brown Incorporated ("BT Alex. Brown") or
its affiliates. There are currently 13 funds in the Flag Investors/ISI Funds
and BT Alex. Brown Cash Reserve Fund, Inc. fund complex (the "Fund Complex").
Mr. Hale serves as Chairman of four funds and as a Director of eight other
funds in the Fund Complex. Mr. Semans serves as Chairman of five funds and as
a Director of six other funds in the Fund Complex. Messrs. Cunnane, Kroeger,
Levy and McDonald serve as Directors of each fund in the Fund Complex. Ms.
Rimel and Mr. Vogt serve as Directors of 11 funds in the Fund Complex. Ms.
Olmert serves as Secretary, Mr. Finelli serves as Treasurer and Mr. Liotta
serves as Assistant Secretary of each of the funds in the Fund Complex.

-11-

<PAGE>

Some of the Directors of the Fund are customers of, and have
had normal brokerage transactions with, BT Alex. Brown in the ordinary course
of business. All such transactions were made on substantially the same terms
as those prevailing at the time for comparable transactions with unrelated
persons. Additional transactions may be expected to take place in the future.

With the exception of the Fund's President, officers of the
Fund receive no direct remuneration in such capacity from the Fund. Officers
and Directors of the Fund who are officers or directors of BT Alex. Brown may
be considered to have received remuneration indirectly. As compensation for
his or her services as director, each Director who is not an "interested
person" of the Fund (as defined in the 1940 Act) (an "Independent Director")
and Mr. Woolf, the Fund's President, receives an aggregate annual fee (plus
reimbursement for reasonable out-of-pocket expenses incurred in connection
with his or her attendance at board and committee meetings) from each fund in
the Fund Complex for which he or she serves. In addition, the Chairman of the
Fund Complex's Audit Committee receives an aggregate annual fee from the Fund
Complex. Payment of such fees and expenses is allocated among all such funds
described above in direct proportion to their relative net assets. For the
fiscal year ended December 31, 1996, Independent Directors' fees attributable
to the assets of the Fund totaled $36,330.

The following table shows aggregate compensation payable to each of
the Fund's Directors by the Fund and the Fund Complex, respectively, and
pension or retirement benefits accrued as part of Fund expenses in the fiscal
year ended December 31, 1996.

-12-

COMPENSATION TABLE
- ------------------------------------------------------------------------------------------------------------------------------------

Name of Person, Position Aggregate Compensation Pension or Retirement Total Compensation
From the Fund Payable to Benefits Accrued As From the Fund
Directors for the Fiscal Year Part of Fund Expenses and Fund Complex
Ended December 31, 1996 Payable to Directors
for the Fiscal Year
Ended December 31, 1996
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>

W. James Price, Chairman(1,2) $0 $0 $0

Charles W. Cole, Jr., Director(1,3) $0 $0 $0

Richard T. Hale, Director)1,3) $0 $0 $0

Truman T. Semans, Director(1,4) $0 $0 $0

James J. Cunnane, Director $3,813(5) (6) $39,000 for service on 12
Boards in the Fund Complex

N. Bruce Hannay, Director(7) $320 (5) (6) $3,321 for service on 12
Boards in the Fund Complex

John F. Kroeger, Director $4,790(5) (6) $49,000 for service on 12
Boards in the Fund Complex

Louis E. Levy, Director $3,813(5) (6) $39,000 for service on 12
Boards in the Fund Complex

Eugene J. McDonald, Director $3,813(5) (6) $39,000 for service on 12
Boards in the Fund Complex

Rebecca W. Rimel, Director(3) $3,441(5) (6) $39,000 for service on 6(8)
Boards in the Fund Complex

Carl W. Vogt, Director(3) $4,576(5) (6) $39,000 for service on 5(8)
Boards in the Fund Complex

Harry Woolf, Director(2) $3,813(5) (6) $39,000 for service on 12
Boards in the Fund Complex
</TABLE>

(1) A Director who is an "interested person" as defined in the 1940 Act.
(2) Retired, effective December 31, 1996. Effective September 1, 1997, Mr.
Woolf serves as President of the Fund and other funds in the Fund
Complex. For serving as President, Mr. Woolf receives compensation from
the Fund and certain other funds in the Fund Complex, in addition to his
retirement benefits.
(3) Messrs. Hale, Cole and Vogt and Ms. Rimel were elected to the Board at a
special meeting of Directors held on April 10, 1996. Mr. Cole subsequently
resigned on September 1, 1997.
(4) Mr. Semans was elected Chairman of the Board, effective January 1, 1997.
(5) Of amounts payable to Messrs. Cunnane, Hannay, Kroeger, Levy, McDonald,
Vogt and Woolf, and to Ms. Rimel, $3,813, $0, $0, $0, $3,813, $4,576,
$3,813 and $3,441, respectively, was deferred pursuant to a deferred
compensation plan.
(6) The Fund Complex has adopted a Retirement Plan for eligible Directors, as
described below. The actuarially computed pension expense for the Fund
for the year ended December 31, 1996 was approximately $19,997.
(7) Retired, effective January 31, 1996 and is now deceased.
(8) Ms. Rimel and Mr. Vogt receive proportionately higher compensation from
each fund for which they serve.

The Fund Complex has adopted a Retirement Plan (the
"Retirement Plan") for Directors who are not employees of the Fund, the
Advisors or their respective affiliates (the "Participants"). After

-13-

<PAGE>

completion of six years of service, each Participant will be entitled to
receive an annual retirement benefit equal to a percentage of the fee earned
by the Participant in his or her last year of service. Upon retirement, each
Participant will receive annually 10% of such fee for each year that he or she
served after completion of the first five years, up to a maximum annual
benefit of 50% of the fee earned by the Participant in his or her last year of
service. The fee will be paid quarterly, for life, by each Fund for which he
or she serves. The Retirement Plan is unfunded and unvested. Mr. Kroeger has
qualified but has not received benefits. The Fund has two Participants, a
Director who retired effective December 31, 1994, and Mr. Woolf who retired
effective December 31, 1996, who have qualified for the Retirement Plan by
serving thirteen and fourteen years, respectively, as Directors in the Fund
Complex and each of whom will be paid a quarterly fee of $4,875 by the Fund
Complex for the rest of his life. Another participant, who retired on January
31, 1996 and died on June 2, 1996, was paid fees of $8,090 by the Fund Complex
under the Retirement Plan in the fiscal year ended December 31, 1996. Such
fees are allocated to each fund in the Fund Complex based upon the relative
net assets of such fund to the Fund Complex.

Set forth in the table below are the estimated annual benefits
payable to a Participant upon retirement assuming various years of service and
payment of a percentage of the fee earned by such Participant in his or her
last year of service, as described above. The approximate credited years of
service at December 31, 1996 are as follows: for Mr. Cunnane, 2 years; for Mr.
Kroeger, 14 years; for Mr. Levy, 2 years; for Mr. McDonald, 4 years; for Ms.
Rimel, 1 year; and for Mr. Vogt, 1 year.

Years of Service Estimated Annual Benefits Payable By Fund Complex Upon Retirement
- ---------------- -----------------------------------------------------------------
Chairman of Audit Committee Other Participants
--------------------------- ------------------
<S> <C> <C>
6 years $4,900 $3,900
7 years $9,800 $7,800
8 years $14,700 $11,700
9 years $19,600 $15,600
10 years or more $24,500 $19,500
</TABLE>

Any Director who receives fees from the Fund is permitted to
defer a minimum of 50%, or up to all, of his or her annual compensation
pursuant to a Deferred Compensation Plan. Messrs. Cunnane, Levy, McDonald and
Vogt and Ms. Rimel have each executed a Deferred Compensation Agreement.
Currently, the deferring Directors may select from among various Flag
Investors funds and BT Alex. Brown Cash Reserve Fund, Inc. in which all or
part of their deferral account shall be deemed to be invested. Distributions
from the deferring Directors' deferral accounts will be paid in cash, in
generally equal quarterly installments over a period of ten years.

Code of Ethics

The Board of Directors of the Fund has adopted a Code of Ethics
pursuant to Rule 17j-1 under the 1940 Act. The Code of Ethics applies to the
personal investing activities of all the directors and officers of the Fund,
as well as to designated officers, directors and employees of the Advisors and
the Distributor. As described below, the Code of Ethics imposes additional
restrictions on the Advisors' investment personnel, including the portfolio
managers and employees who execute or help execute a

-14-

<PAGE>

portfolio manager's decisions or who obtain contemporaneous information
regarding the purchase or sale of a security by the Fund.

The Code of Ethics requires that any officer, director, or
employee of the Fund, or the Advisors or, in the case of the Distributor if
they are access persons, preclear personal securities investments (with
certain exceptions, such as non-volitional purchases or purchases that are
part of an automatic dividend reinvestment plan). The preclearance requirement
and associated procedures are designed to identify any substantive prohibition
or limitation applicable to the proposed investment. The substantive
restrictions applicable to investment personnel include a ban on acquiring any
securities in an initial public offering, a prohibition from profiting on
short-term trading in securities and special preclearance of the acquisition
of securities in private placements. Furthermore, the Code of Ethics provides
for trading "blackout periods" that prohibit trading by investment personnel
and certain other employees within periods of trading by the Fund in the same
security. Trading by investment personnel and certain other employees of the
Advisor or Sub Advisor, as appropriate, would be exempt from this "blackout
period" provided that (1) the market capitalization of a particular security
exceeds $2 billion; and (2) orders of such entity do not exceed ten percent of
the daily average trading volume of the security for the prior 15 days.
Officers, directors and employees of the Advisors and the Distributor may
comply with codes instituted by those entities so long as they contain similar
requirements and restrictions.

6. INVESTMENT ADVISORY AND OTHER SERVICES

On June 17, 1997, the Board of Directors of the Fund, including
a majority of the Independent Directors, approved an Investment Advisory
Agreement between the Fund and Investment Company Capital Corp. ("ICC" or the
"Advisor") and a Sub-Advisory Agreement among the Fund, ICC and Alex. Brown
Investment Management ("ABIM" or the "Sub-Advisor"), both of which contracts
are described in greater detail below. The Investment Advisory Agreement and
the Sub-Advisory Agreement were approved by shareholders of the Fund on August
14, 1997. ICC, the investment advisor, is an indirect subsidiary of Bankers
Trust New York Corporation. ABIM is a limited partnership affiliated with the
Advisor. Buppert, Behrens & Owens, Inc. a company organized and owned by three
employees of ABIM, owns a 49% limited partnership interest in ABIM. BT Alex.
Brown owns a 1% general partnership interest in ABIM and BT Alex. Brown
Holdings, Inc. owns the remaining limited partnership interest. ICC also
serves as investment advisor and ABIM serves as sub-advisor to other funds in
the Flag Investors family of funds.

Under the Investment Advisory Agreement, ICC obtains and
evaluates economic, statistical and financial information to formulate and
implement investment policies for the Fund. ICC has delegated this
responsibility to ABIM provided that ICC continues to supervise the
performance of ABIM and report thereon to the Fund's Board of Directors. Any
investment program undertaken by ICC or ABIM will at all times be subject to
policies and control of the Fund's Board of Directors. ICC will provide the
Fund with office space for managing its affairs, with the services of required
executive personnel and with certain clerical and bookkeeping services and
facilities. These services are provided by ICC without reimbursement by the
Fund for any costs. Neither ICC nor ABIM shall be liable to the Fund or its
shareholders for any act or omission by ICC or ABIM or any losses sustained by
the Fund or its shareholders except in the case of willful misfeasance, bad
faith, gross negligence, or reckless disregard of duty. The services of ICC
and ABIM to the Fund are not exclusive and ICC and ABIM are free to render
similar services to others.

-15-

<PAGE>

As compensation for its services, ICC is entitled to receive a
fee from the Fund, calculated daily and paid monthly, at the following annual
rates based upon the Fund's average daily net assets: 0.85% of the first $100
million, 0.75% of the next $100 million, 0.70% of the next $100 million, 0.65%
of the next $200 million, 0.58% of the next $500 million, 0.53% of the next
$500 million and 0.50% of that portion exceeding $1.5 billion. Prior to April
11, 1995, the annual rates based upon the Fund's average daily net assets
were: 0.65% of the first $100 million, 0.55% of the next $100 million, 0.50%
of the next $100 million and 0.45% of that portion in excess of $300 million.
As compensation for its services, ABIM is entitled to receive a fee from ICC,
payable from its advisory fee, calculated daily and paid monthly, at the
following annual rates based upon the Fund's average daily net assets: 0.60%
of the first $100 million, 0.55% of the next $100 million, 0.50% of the next
$100 million, 0.45% of the next $200 million, 0.40% of the next $500 million,
0.37% of the next $500 million and 0.35% of that portion in excess of $1.5
billion.

Each of the Investment Advisory Agreement and the Sub-Advisory
Agreement has an initial term of two years and will continue in effect from
year to year thereafter if such continuance is specifically approved at least
annually by the Fund's Board of Directors, including a majority of the
Independent Directors who have no direct or indirect financial interest in
such agreements, by votes cast in person at a meeting called for such purpose,
or by a vote of a majority of the outstanding Shares (as defined under
"Capital Stock"). The Fund or ICC may terminate the Investment Advisory
Agreement on sixty days' written notice without penalty. The Investment
Advisory Agreement will terminate automatically in the event of assignment (as
defined in the 1940 Act). The Sub-Advisory Agreement has similar termination
provisions. Prior to April 10, 1996, ICC served as the Fund's investment
advisor and ABIM served as the Fund's sub-advisor pursuant to agreements
approved by shareholders on December 6, 1988.

Advisory fees paid by the Fund to ICC and sub-advisory fees
paid by ICC to ABIM for the last three fiscal years were as follows:

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

* Net of fee waivers. Such voluntary fee waivers were discontinued on
October 6, 1995.

ICC also serves as the Fund's transfer and dividend
disbursing agent and provides accounting services to the Fund. An affiliate of
ICC serves as the Fund's custodian. See "Custodian, Transfer Agent and
Accounting Services."

-16-

<PAGE>

7. DISTRIBUTION OF FUND SHARES

ICC Distributors, Inc. ("ICC Distributors" or the "Distributor")
serves as the distributor of each class of the Fund's Shares pursuant to a
Distribution Agreement (the "Distribution Agreement") effective August 31,
1997. Prior to August 31, 1997, Alex. Brown & Sons Incorporated ("Alex.
Brown") served as the Fund's distributor for the same rate of compensation and
on substantially the same terms and conditions as ICC Distributors.

The Distribution Agreement provides that ICC Distributors
shall; (i) use reasonable efforts to sell Shares upon the terms and conditions
contained in the Distribution Agreement and the Fund's then current
Prospectus; (ii) use its best efforts to conform with the requirements of all
federal and state laws relating to the sale of the Shares; (iii) adopt and
follow procedures as may be necessary to comply with the requirements of the
National Association of Securities Dealers, Inc. and any other applicable
self-regulatory organization; (iv) perform its duties under the supervision of
and in accordance with the directives of the Fund's Board of Directors and the
Fund's Articles of Incorporation and By-Laws; and (v) provide the Fund's Board
of Directors with a written report of the amounts expended in connection with
the Distribution Agreement. ICC Distributors shall devote reasonable time and
effort to effect sales of Shares but shall not be obligated to sell any
specific number of Shares. The services of ICC Distributors are not exclusive
and ICC Distributors shall not be liable to the Fund or its shareholders for
any error of judgment or mistake of law, for any losses arising out of any
investment, or for any action or inaction in the absence of bad faith, willful
misfeasance or gross negligence in the performance of its duties or
obligations under the Distribution Agreement or by reason of its reckless
disregard of its duties and obligations under the Distribution Agreement. The
Distribution Agreement further provides that the Fund and ICC Distributors
will mutually indemnify each other for losses relating to disclosures in the
Fund's registration statement.

The Distribution Agreement may be terminated at any time upon
60 days' written notice by the Fund, without penalty, by the vote of a
majority of the Fund's Independent Directors or by a vote of a majority of the
outstanding Shares of the related class (as defined under "Capital Stock") or
upon 60 days' written notice by the Distributor and shall automatically
terminate in the event of an assignment. The Distribution Agreement has an
initial term of one year from the date of effectiveness. It shall continue in
effect thereafter with respect to each class of the Fund provided that it is
approved at least annually by (i) a vote of a majority of the outstanding
voting securities of the related class of the Fund; or (ii) a vote of a
majority of the Fund's Board of Directors including a majority of the
Independent Directors and, with respect to each class of the Fund for which
there is a plan of distribution, so long as such plan of distribution is
approved at least annually by the Independent Directors in person at a meeting
called for the purpose of voting on such approval. The Distribution Agreement,
including the form of Sub-Distribution Agreement, was initially approved by
the Board of Directors, including a majority of the Independent Directors, on
August 4, 1997.

ICC Distributors and certain broker-dealers ("Participating
Dealers") have entered into Sub-Distribution Agreements under which such
broker-dealers have agreed to process investor purchase and redemption orders
and respond to inquiries from Fund shareholders concerning the status of their
accounts and the operations of the Fund. Any Sub-Distribution Agreement may be
terminated in the same manner as the Distribution Agreement and shall
automatically terminate in the event of an assignment.

In addition, with respect to Class A and Class B Shares, the
Fund may enter into Shareholder Servicing Agreements with certain financial
institutions, such as BT Alex. Brown and certain

-17-

<PAGE>

banks, to act as Shareholder Servicing Agents, pursuant to which ICC
Distributors will allocate a portion of its distribution fee as compensation
for such financial institutions' ongoing shareholder services. The Fund may
also enter into Shareholder Servicing Agreements pursuant to which the Advisor
or its affiliates will provide compensation out of its own resources for
ongoing shareholder services. Although banking laws and regulations prohibit
banks from distributing shares of open-end investment companies such as the
Fund, according to interpretations by various bank regulatory authorities,
financial institutions are not prohibited from acting in other capacities for
investment companies, such as the shareholder servicing capacities described
above. Should future legislative, judicial or administrative action prohibit
or restrict the activities of the Shareholder Servicing Agents in connection
with the Shareholder Servicing Agreements, the Fund may be required to alter
materially or discontinue its arrangements with the Shareholder Servicing
Agents. Such financial institutions may impose separate fees in connection
with these services.

As compensation for providing distribution services as
described above for the Class A Shares, the Fund will pay ICC Distributors an
annual fee, paid monthly equal to .25% of the average daily net assets of the
Class A Shares. As compensation for providing distribution services as
described above for the Class B Shares, the Fund will pay ICC Distributors an
annual fee, paid monthly, equal to .75% of the average daily net assets of the
Class B Shares. With respect to the Class A Shares, ICC Distributors expects
to allocate up to all of its fee to Participating Dealers and Shareholder
Servicing Agents. With respect to the Class B Shares, ICC Distributors expects
to retain the entire distribution fee as reimbursement for front-end payments
to Participating Dealers. In addition, with respect to the Class B Shares, the
Fund will pay ICC Distributors a shareholder servicing fee at an annual rate
of .25% of the average daily net assets of the Class B Shares. (See the
Prospectus.) ICC Distributors expects to allocate most of its shareholder
servicing fee to Participating Dealers and Shareholder Servicing Agents. ICC
Distributors does not receive compensation for distributing the Institutional
Shares.

As compensation for providing distribution and shareholder
services to the Fund for the last three fiscal years, Alex. Brown received
aggregate fees in the following amounts:

- ------------------------------------------------------------------------------
Year Ended December 31,
- ------------------------------------------------------------------------------
Fee 1996 1995 1994
- ------------------------------------------------------------------------------
Class A 12b-1 Fee $1,251,568 $1,153,794 $1,155,931
- ------------------------------------------------------------------------------
Class B 12b-1 Fee $ 98,828 $ 26,347* --
- ------------------------------------------------------------------------------
Class B Shareholder $ 32,943 $ 8,783* --
- ------------------------------------------------------------------------------
Servicing Fee
- ------------------------------------------------------------------------------
Class D 12b-1 Fee ** $ 176,582 $ 189,406 $ 185,856
- ------------------------------------------------------------------------------
Total Fees $1,559,921 $1,378,330 $1,341,787
- ------------------------------------------------------------------------------

- ---------
* For the period from January 3, 1995 (commencement of operations)
through December 31, 1995.
** For the period from April 6, 1993 through November 18, 1994, the Fund
offered the Flag Investors Telephone Income Fund Class D Shares
(which were known at such time as the Flag Investors Telephone Income
Fund Class B Shares.) Some Class D Shares remain outstanding.

-18-

<PAGE>

Pursuant to Rule 12b-1 under the 1940 Act, which provides that
investment companies may pay distribution expenses, directly or indirectly,
only pursuant to a plan adopted by the investment company's board of directors
and approved by its shareholders, the Fund has adopted a Plan of Distribution
for Class A Shares and one for Class B Shares (the "Plans"). Under the Plans,
the Fund pays a fee to ICC Distributors for distribution and other shareholder
servicing assistance as set forth in the Distribution Agreement, and ICC
Distributors is authorized to make payments out of its fees to Participating
Dealers and Shareholder Servicing Agents. The Plans remain in effect from year
to year thereafter as specifically approved (a) at least annually by the
Fund's Board of Directors and (b) by the affirmative vote of a majority of the
Independent Directors, by votes cast in person at a meeting called for such
purpose. The Plans were most recently approved by the Board of Directors,
including a majority of the Independent Directors, on September 16, 1997.

In approving the Plans, the Directors concluded, in the
exercise of reasonable business judgment, that there was a reasonable
likelihood that the Plans would benefit the Fund and its shareholders. The
Plans will be renewed only if the Directors make a similar determination in
each subsequent year. The Plans may not be amended to increase materially the
fee to be paid pursuant to the Distribution Agreement without the approval of
the shareholders of the Fund. The Plans may be terminated at any time upon
sixty days' notice, in either case without penalty, by the vote of a majority
of the Independent Directors or by a vote of a majority of the outstanding
class of Shares (as defined under "Capital Stock").

During the continuance of the Plans, the Fund's Board of
Directors will be provided for their review, at least quarterly, a written
report concerning the payments made under the Plans to ICC Distributors
pursuant to the Distribution Agreement and to broker-dealers pursuant to
Sub-Distribution Agreements. Such reports shall be made by the persons
authorized to make such payments. In addition, during the continuance of the
Plans, the selection and nomination of the Fund's Independent Directors shall
be committed to the discretion of the Independent Directors then in office.

If either Plan is terminated in accordance with its terms, the
obligation of the Fund to make payments to ICC Distributors pursuant to the
Plan will cease and the Fund will not be required to make any payments past
the date the Distribution Agreement terminates with respect to that class. In
return for payments received pursuant to the Plans for the last three fiscal
years, Alex. Brown paid the distribution related expenses of the related
classes including one or more of the following: printing and mailing of
prospectuses to other than current shareholders; compensation to dealers and
sales personnel; and interest, carrying, or other financing charges.

-19-

<PAGE>

Alex. Brown received commissions on the sale of Class A Shares
of which only a portion was retained, and contingent deferred sales loads on
the Class B Shares, in the following amounts:

<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------
Fiscal Year Ended December 31,
- ----------------------------------------------------------------------------------------------------------------------
Class 1996 1995 1994
- ----------------------------------------------------------------------------------------------------------------------
Received Retained Received Retained Received Retained
- ----------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Class A $717,441 $255,062 $146,261 $73,667 $812,666 $260,734
Commissions
- ----------------------------------------------------------------------------------------------------------------------
Class B $377,125 $377,125 $78,146 $78,146 $377,125 $ 78,146
Contingent
Deferred Sales
Charge
- ----------------------------------------------------------------------------------------------------------------------
</TABLE>

Except as described elsewhere, the Fund pays or causes to be
paid all continuing expenses of the Fund, including, without limitation:
investment advisory and distribution fees; the charges and expenses of any
registrar, any custodian or depository appointed by the Fund for the
safekeeping of cash, portfolio securities and other property, and any
transfer, dividend or accounting agent or agents appointed by the Fund;
brokers' commissions chargeable to the Fund in connection with portfolio
securities transactions to which the Fund is a party; all taxes, including
securities issuance and transfer taxes, and fees payable by the Fund to
federal, state or other governmental agencies; the costs and expenses of
engraving or printing of certificates representing Shares; all costs and
expenses in connection with the registration and maintenance of registration
of the Fund and its Shares with the SEC and various states and other
jurisdictions (including filing fees, legal fees and disbursements of
counsel); the costs and expenses of printing, including typesetting and
distributing prospectuses and statements of additional information of the Fund
and supplements thereto to the Fund's shareholders; all expenses of
shareholders' and Directors' meetings and of preparing, printing and mailing
proxy statements and reports to shareholders; fees and travel expenses of
Directors and Director members of any advisory board or committee; all
expenses incident to the payment of any dividend, distribution, withdrawal or
redemption, whether in Shares or in cash; charges and expenses of any outside
service used for pricing of the Shares; fees and expenses of legal counsel,
including counsel to the Independent Directors, and of independent certified
public accountants, in connection with any matter relating to the Fund;
membership dues of industry associations; interest payable on Fund borrowings;
postage; insurance premiums on property or personnel (including Officers and
Directors) of the Fund that inure to its benefit; extraordinary expenses
(including, but not limited to, legal claims and liabilities and litigation
costs and any indemnification related thereto); and all other charges and
costs of the Fund's operation unless otherwise explicitly assumed by ICC,
ABIM, or ICC Distributors.

8. BROKERAGE

ABIM is responsible for decisions to buy and sell securities
for the Fund, for the broker-dealer selection and for negotiation of
commission rates, subject to the supervision of ICC. Purchases and sales of
securities on a securities exchange are effected through broker-dealers who
charge a commission for their services. Brokerage commissions are subject to
negotiation between ABIM and the broker-dealers. ABIM may direct purchase and
sale orders to any broker-dealer, including, to the extent and in the manner
permitted by applicable law, its affiliates and ICC Distributors.

-20-

<PAGE>

In over-the-counter transactions, orders are placed directly
with a principal market maker and such purchases normally include a mark up
over the bid to the broker-dealer based on the spread between the bid and
asked price for the security. Purchases from underwriters of portfolio
securities include a commission or concession paid by the issuer to the
underwriter. On occasion, certain money market instruments may be purchased
directly from an issuer without payment of a commission or concession. The
Fund will not deal with the Advisors or their affiliates in any transaction in
which the Advisors or their affiliates act as a principal, nor will the Fund
buy or sell over-the-counter securities with the Advisors or their affiliates
acting as market maker.

If the Advisors or their affiliates are participating in an
underwriting or selling group, the Fund may not buy portfolio securities from
the group except in accordance with rules of the SEC. The Fund believes that
the limitation will not affect its ability to carry out its present investment
objective.

ABIM's primary consideration in effecting securities
transactions is to obtain best price and execution of orders on an overall
basis. As described below, however, ABIM may, in its discretion, effect
transactions with dealers that furnish statistical, research or other
information or services that are deemed by ABIM to be beneficial to the Fund's
investment program. Certain research services furnished by broker-dealers may
be useful to ABIM with clients other than the Fund. Similarly, any research
services received by ABIM through placement of portfolio transactions of other
clients may be of value to ABIM in fulfilling its obligations to the Fund. No
specific value can be determined for research and statistical services
furnished without cost to ABIM by a broker-dealer. ABIM is of the opinion that
because the material must be analyzed and reviewed by its staff, its receipt
does not tend to reduce expenses, but may be beneficial in supplementing
ABIM's research and analysis. Therefore, it may tend to benefit the Fund by
improving ABIM's investment advice. ABIM's policy is to pay a broker-dealer
higher commissions for particular transactions than might be charged if a
different broker-dealer had been chosen when, in ABIM's opinion, this policy
furthers the overall objective of obtaining best price and execution. Subject
to periodic review by the Fund's Board of Directors, ABIM is also authorized
to pay broker-dealers other than the Advisors or their affiliates higher
commissions than another broker might have charged on brokerage transactions
for the Fund for brokerage or research services. The allocation of orders
among broker-dealers and the commission rates paid by the Fund will be
reviewed periodically by the Board.

Subject to the above considerations, the Board of Directors has
authorized the Fund to effect portfolio transactions, on an agency basis,
through the Advisors or their affiliates. At the time of such authorization
the Board adopted certain policies and procedures incorporating the standards
of Rule 17e-1 under the 1940 Act which requires that the commissions paid the
Advisors or their affiliates must be "reasonable and fair compared to the
commission, fee or other remuneration received or to be received by other
brokers in connection with comparable transactions involving similar
securities during a comparable period of time." Rule 17e-1 also contains
requirements for the review of such transactions by the Board of Directors and
requires ICC and ABIM to furnish reports and to maintain records in connection
with such reviews.

ABIM manages other investment accounts. It is possible that, at
times, identical securities will be acceptable for the Fund and one or more of
such other accounts; however, the position of each account in the securities
of the same issuer may vary and the length of time that each account may
choose to hold its investment in such securities may likewise vary. The timing
and amount of purchase by each account will also be determined by its cash
position. If the purchase or sale of securities consistent with the investment
policies of the Fund or one or more of these accounts is considered at or
about the same time, transactions in such securities will be allocated among
the accounts in a manner deemed equitable by ABIM. ABIM may combine such
transactions, in accordance with applicable laws

-21-

<PAGE>

and regulations, in order to obtain the best net price and most favorable
execution. Such simultaneous transactions, however, could adversely affect the
ability of the Fund to obtain or dispose of the full amount of a security that
it seeks to purchase or sell.

ICC directed transactions to broker-dealers and paid related
commissions because of research services in the following amounts:

- ------------------------------------------------------------------------------
Fiscal Year Ended March 31,
- ------------------------------------------------------------------------------
1996 1995 1994
- ------------------------------------------------------------------------------
Transactions Directed $ 191,851,754 $ 288,166,553 $208,696,174
- ------------------------------------------------------------------------------
Commissions Paid $ 396,046 $ 386,539 $ 254,895
- ------------------------------------------------------------------------------

In the fiscal years ended December 31, 1996, December 31, 1995
and December 31, 1994, the Fund paid Alex. Brown brokerage commissions in the
aggregate amount of $7,000, $0 and $7,000, which represented 1.9%, 0.0% and
2.7% of the Fund's aggregate brokerage commissions for the periods and which
were paid on transactions that represented 2.9%, 0.0% and 1.8%, respectively,
of the aggregate dollar amount of transactions that incurred commissions paid
by the Fund during the respective periods. The Fund is required to identify
any securities of its "regular brokers or dealers" (as such term is defined in
the 1940 Act) that the Fund has acquired during its most recent fiscal year.
As of December 31, 1996, the Fund held a 6.0% repurchase agreement issued by
Goldman Sachs & Co. valued at $5,410,000. Goldman Sachs & Co. is a "regular
broker or dealer" of the Fund.

9. CAPITAL STOCK

Under the Fund's Articles of Incorporation, the Fund has 85
million authorized Shares of common stock, with a par value of $.001 per
share. The Board of Directors may increase or decrease the number of
authorized Shares without shareholder approval. On October 11, 1989, the Fund
declared a two for one stock dividend payable to shareholders of record on
October 27, 1989.

The Fund's Articles of Incorporation provide for the
establishment of separate series and separate classes of Shares by the
Directors at any time. The Fund currently has one Series and the Board has
designated four classes of Shares: Flag Investors Telephone Income Fund Class
A Shares, Flag Investors Telephone Income Fund Class B Shares, Flag Investors
Telephone Income Fund Class D Shares and Flag Investors Telephone Income Fund
Institutional Shares. The Flag Investors Telephone Income Fund Class D Shares
are not currently being offered. In the event separate series are established,
all Shares of the Fund, regardless of series or class, would have equal rights
with respect to voting, except that with respect to any matter affecting the
rights of the holders of a particular series or class, the holders of each
series or class would vote separately. In general, each such series would be
managed separately and shareholders of each series would have an undivided
interest in the net assets of that series. For tax purposes, the series would
be treated as separate entities. Generally, each class of Shares issued by a
particular series would be identical to every other class and expenses of the
Fund (other than 12b-1 fees and any applicable services fees) are prorated
between all classes of a series based upon the relative net assets of each
class. Any matters affecting any class exclusively will be voted on by the
holders of such class.

-22-

<PAGE>

Shareholders of the Fund do not have cumulative voting rights,
and therefore the holders of more than 50% of the outstanding Shares voting
together for election of Directors may elect all the members of the Board of
Directors of the Fund. In such event, the remaining holders cannot elect any
members of the Board of Directors of the Fund. There are no preemptive,
conversion or exchange rights applicable to any of the Shares. The issued and
outstanding Shares are fully paid and non-assessable. In the event of
liquidation or dissolution of the Fund, each Share is entitled to its portion
of the Fund's assets (or the assets allocated to a separate series of shares
if there is more than one series) after all debts and expenses have been paid.

As used in this Statement of Additional Information, the term
"majority of the outstanding Shares" means the vote of the lesser of (i) 67%
or more of the Shares present at a meeting, if the holders of more than 50% of
the outstanding Shares are present or represented by proxy, or (ii) more than
50% of the outstanding Shares.

10. SEMI-ANNUAL REPORTS

The Fund furnishes shareholders with semi-annual reports
containing information about the Fund and its operations, including a list of
investments held in the Fund's portfolio and financial statements. The annual
financial statements are audited by the Fund's independent accountants.

11. CUSTODIAN, TRANSFER AGENT AND ACCOUNTING SERVICES

Effective September 22, 1997, Bankers Trust Company ("Bankers
Trust") has been retained to serve as custodian of the Fund's investments.
Prior to September 22, 1997, PNC Bank, National Association ("PNC Bank")
served as custodian of the Fund's investments. Bankers Trust receives such
compensation from the Fund for its services as Custodian as may be agreed to
from time to time by Bankers Trust and the Fund. Investment Company Capital
Corp. has been retained to act as transfer and dividend disbursing agent. As
compensation for providing these services, the Fund pays ICC up to $10.12 per
account per year, plus reimbursement for out-of-pocket expenses incurred in
connection therewith. For the fiscal year ended December 31, 1996, such fees
totaled $623,604.

ICC also provides certain accounting services to the Fund under
a Master Services Agreement between the Fund and ICC. As compensation for
these services, ICC receives an annual fee, calculated daily and paid monthly
as shown below.

Average Net Assets Incremental Annual Accounting Fee
------------------ ---------------------------------

$ 0 - $ 10,000,000 $13,000(fixed fee)
$ 10,000,000 - $ 20,000,000 .100%
$ 20,000,000 - $ 30,000,000 .080%
$ 30,000,000 - $ 40,000,000 .060%
$ 40,000,000 - $ 50,000,000 .050%
$ 50,000,000 - $ 60,000,000 .040%
$ 60,000,000 - $ 70,000,000 .030%
$ 70,000,000 - $ 100,000,000 .020%
$100,000,000 - $ 500,000,000 .015%
$500,000,000 - $1,000,000,000 .005%
over $1,000,000,000 .001%

-23-

<PAGE>

In addition, the Fund reimburses ICC for certain
out-of-pocket expenses incurred in connection with ICC's provision of
accounting services under the Master Services Agreement.

As compensation for providing accounting services to the
Fund for the fiscal year ended December 31, 1996, ICC received fees of
$117,160.

12. INDEPENDENT ACCOUNTANTS

The annual financial statements of the Fund are audited by Coopers
& Lybrand L.L.P. whose report thereon appears elsewhere herein, and have been
included herein in reliance upon the report of such firm of accountants given
on their authority as experts in accounting and auditing.

13. PERFORMANCE INFORMATION

For purposes of quoting and comparing the performance of the Fund
to that of other open-end diversified management investment companies and to
stock or other relevant indices in advertisements or in certain reports to
shareholders, performance will be stated in terms of total return rather than
in terms of yield. The total return quotations, under the rules of the SEC,
must be calculated according to the following formula:

n
P(l + T) = ERV

Where: P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years (1, 5 or 10)
ERV = ending redeemable value at the end of the 1-, 5-
or 10-year periods (or fractional portion thereof) of
a hypothetical $1,000 payment made at the beginning of
the 1-, 5- or 10-year periods.

Under the foregoing formula, the time periods used in advertising
will be based on rolling calendar quarters, updated to the last day of the
most recent quarter prior to submission of the advertising for publication,
and will cover one-, five- and ten-year periods or a shorter period dating
from the effectiveness of the Fund's registration statement (or the later
commencement of operations of the series or class). In calculating the ending
redeemable value for the Class A Shares, the maximum sales load (4.5%) is
deducted from the initial $1,000 payment and all dividends and distributions
by the Fund are assumed to have been reinvested at net asset value as
described in the Prospectus on the reinvestment dates during the period. In
calculating the performance of the Class B Shares, the applicable contingent
deferred sales charge (4.0% for the one-year period, 2.0% for the five-year
period and no sales charge thereafter) is deducted from the ending redeemable
value and all dividends and distributions by the Fund are assumed to have been
reinvested at net asset value as described in the prospectus on the
reinvestment dates during the period. "T" in the formula above is calculated
by finding the average annual compounded rate of return over the period that
would equate an assumed initial payment of $1,000 to the ending redeemable
value. Any sales loads that might in the future be

-24-

<PAGE>

made applicable at the time to reinvestments would be included as would any
recurring account charges that might be imposed by the Fund.

Calculated according to SEC rules, the ending redeemable value and
average annual total return of a hypothetical $1,000 payment for the periods
ended December 31, 1996 were as follows:

One-Year Period Ended Five-Year Period Ended Ten-Year Period Ended Inception Through
December 31, 1996 December 31, 1996 December 31, 1996 December 31, 1996
------------------- ------------------- ------------------- ------------------
- ------------------------------------------------------------------------------------------------------------------------------------
Ending Average Ending Average Ending Average Ending Average
Redeemable Annual Total Redeemable Annual Total Redeemable Annual Total Redeemable Annual Total
Class Value Return Value Return Value Return Value Return
- ----- ----- ------ ----- ------ ----- ------ ----- ------
<S> <C> <C> <C> <C> <C> <C>
- ------------------------------------------------------------------------------------------------------------------------------------
Class A $1,083.50 8.35% $1,798.78 12.46% $3,708.39 14.00% * *
January 18, 1984+
- ------------------------------------------------------------------------------------------------------------------------------------
Class B $1,095.74 9.57% N/A N/A N/A N/A $1,450.99 20.52%
January 3, 1995+
- ------------------------------------------------------------------------------------------------------------------------------------
Class D $1,105.74 10.57% N/A N/A N/A N/A $1,490.03 11.21%
April 6, 1993+
- ------------------------------------------------------------------------------------------------------------------------------------
</TABLE>

+ Inception Date.
* Not required since more than ten years have elapsed since inception.

The Fund may also from time to time include in such advertising
total return figures that are not calculated according to the formula set
forth above in order to compare more accurately the Fund's performance with
other measures of investment return. For example, in comparing the Fund's
total return with data published by Lipper Analytical Services, Inc., CDA
Investment Technologies, Inc. or Morningstar Inc., or with the performance of
the Lehman Brothers Government Corporate Bond Index, the Consumer Price Index,
the return on 90-day U.S. Treasury bills, the Standard and Poor's 500 Stock
Index or the Dow Industrial Average, the Fund calculates its aggregate and
average annual total return for the specified periods of time by assuming the
investment of $10,000 in Shares and assuming the reinvestment of each dividend
or other distribution at net asset value on the reinvestment date. For this
alternative computation, the Fund assumes that the $10,000 invested in Shares
is net of all sales charges. The Fund will, however, disclose the maximum
sales charges and will also disclose that the performance data do not reflect
sales charges and that inclusion of sales charges would reduce the performance
quoted. Such alternative total return information will be given no greater
prominence in such advertising than the information prescribed under SEC
rules, and all advertisements containing performance data will include a
legend disclosing that such performance data represent past performance and
that the investment return and principal value of an investment will fluctuate
so that an investor's shares, when redeemed, may be worth more or less than
their original cost.

The Fund's annual portfolio turnover rate (the lesser of the
value of the purchases or sales for the year divided by the average monthly
market value of the portfolio during the year, excluding U.S. Government and
short-term securities) may vary from year to year, as well as within a year,
depending on market conditions. The Fund's portfolio turnover rate in fiscal
year 1996 was 20% and in fiscal year 1995 was 24%.

Morningstar Mutual Fund Advisory Service ("Morningstar") assigned
the Fund their "5" Best in Category rating among the ten funds in the
communications funds category for the three-year period ended December 31,
1997. As of December 31, 1997, Morningstar assigned the Fund a weighted

-25-

<PAGE>

overall risk-adjusted rating of four stars based on the three-, five- and
ten-year ratings (see explanation below). As of December 31, 1997, the Fund's
ratings for separate periods within its investment category of domestic equity
funds, were three stars among 2,332 funds for three years, three stars among
1,292 funds for five years and four stars among 676 funds for ten years.

The Morningstar risk-adjusted rating is expressed on a scale of 1
to 5 stars. The star rating is neither a predictive measure nor a "buy/sell"
recommendation. It is a purely descriptive representation of how well a fund
has balanced risk and return in the past. If the fund scores in the top 10% of
its investment category, it receives 5 stars (Highest); if it falls in the
next 22.5%, it receives 4 stars (Above Average); if it falls in the middle
35%, it receives 3 stars (Neutral or Average); if it falls in the next 22.5%,
it receives two stars (Below Average); and if it falls in the bottom 10%, it
receives 1 star (Lowest). The star ratings are recalculated monthly. The
Fund's overall risk-adjusted star rating is a weighted average of the Fund's
three-, five-, and 10-year histories, relative to other funds in its broad
investment category (i.e, equity). The three time periods are combined as a
weighted average. The 10-year rating accounts for 50% of the overall rating,
the five-year figure for 30%, and the three-year period 20%.

14. CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES

To Fund management's knowledge, the following persons held
beneficially or of record 5% or more of the Fund's outstanding shares, as of
April 15, 1997:

Alex. Brown & Sons Incorporated 26.2%*
One South Street
Baltimore, Maryland
----------
* As of such date, Alex. Brown owned beneficially
less than 1% of such Shares.

As of April 15, 1997, the Directors and officers as a group owned
less than 1% of the Fund's total outstanding shares.

15. FINANCIAL STATEMENTS

See next page.

-26-

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND
- --------------------------------------------------------------------------------
Statement of Net Assets December 31, 1996

Market Value
Shares Security (Note 1)
- ------------------------------------------------------------------------------

TELEPHONE INDUSTRY--90.3%

Common Stock--90.3%
220,408 AirTouch Communications Inc.* $ 5,565,302
600,000 America Online, Inc. 19,950,000
394,000 Ameritech Corporation 23,886,250
224,224 AT&T Corporation 9,753,744
370,000 BCE Inc. 17,667,500
497,608 Bell Atlantic Corporation 32,220,118
223,464 BellSouth Corporation 9,022,359
366,428 BlackBox Corporation* 15,115,155
290,000 BroadBand Technologies Inc.* 4,277,500
115,000 CellStar Corporation* 2,070,000
595,800 Cincinnati Bell Inc. 36,716,175
200,000 DSC Communications Corporation* 3,575,000
25,000 Excel Communications Inc.* 525,000
1,022,400 Frontier Corporation 23,131,800
214,700 General Instrument Corporation* 4,642,888
823,320 GTE Corporation 37,461,060
496,841 LCI International Inc. 10,682,081
181,235 Lucent Technologies Inc. 8,382,119
440,000 MFS Communications Co. Inc.* 23,980,000
405,000 Mobile Telecommunication 3,442,500
340,000 Motorola Inc. 20,867,500
200,000 NEXTEL Communications Inc.--Class A* 2,612,500
250,000 Octel Communications Corporation* 4,375,000
435,347 Orbital Sciences Corporation* 7,509,736
1,373,808 Pacific Telesis Group 50,487,444
130,000 Preferred Networks Inc.* 845,000
140,000 QUALCOMM Inc.* 5,582,500
969,106 SBC Communications Inc. 50,151,235
690,000 Southern New England
Telecommunications Corporation 26,823,750
128,000 Telefonica de Espana SA ADR 8,864,000
500,000 Telefonos de Mexico SA ADR--Series L 16,500,000
148,000 U.S. Robotics Corporation* 10,656,000
------------

Total Common Stock
(Cost $327,639,322) 497,341,216
------------

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND
- ------------------------------------------------------------------------------
Statement of Net Assets (concluded) December 31, 1996

Shares/ Market Value
Par (000) Security (Note 1)
- ------------------------------------------------------------------------------

NON-TELEPHONE INDUSTRY--8.5%

Common Stock--7.6%
626,900 Alexander Haagen Properties, Inc. $ 9,246,775
367,774 Conseco Inc. 23,445,593
67,700 Meditrust Corporation 2,708,000
100,000 Nationwide Health Properties, Inc. 2,425,000
122,128 Simon DeBartolo Group, Inc. 3,785,968
------------
Total Common Stock
(Cost $18,040,909) 41,611,336
------------
Corporate Bond--0.9%
$ 5,000 HMH Properties, 9.5%, 5/15/05
(Cost $4,910,351) 5,225,000
------------

Total Non-Telephone Industry
(Cost $22,951,260) 46,836,336
------------

REPURCHASE AGREEMENT--1.0%
5,410 Goldman Sachs & Co., 6.00%
Dated 12/31/96, to be repurchased on
1/2/97, collateralized by U.S. Treasury
Notes with a market value of $5,518,672.
(Cost $5,410,000) 5,410,000
------------
Total Investments in Securities--99.8%
(Cost $356,000,582)** 549,587,552
------------
Other Assets in Excess of Liabilities, Net--0.2% 1,016,790
------------
Net Assets--100.0% $550,604,342
============

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND
- --------------------------------------------------------------------------------
Net Asset Value Per:
Class A Share
($505,371,023 / 32,421,696 shares outstanding) $15.59(dagger)
=======
Class B Share
($17,660,516 / 1,138,610 shares outstanding) $15.51(double daggers)
=======
Class D Share
($27,572,803 / 1,768,618 shares outstanding) $15.59(triple daggers)
=======
Maximum Offering Price Per:
Class A Share
($15.59 / .955) $16.32
=======
Class B Share $15.51
=======
Class D Share
($15.59 / .985) $15.83
=======

- ---------------
* Non-income producing security.

** Aggregate cost for federal tax purposes was $352,513,493.

(dagger) Redemption value is $15.59.

(double daggers) Redemption value is $14.89 following 4.00% maximum contingent
deferred sales charge.

(triple daggers) Redemption value is $15.43 following 1.00% maximum contingent
deferred sales charge.

See Notes to Financial Statements.

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND
- -------------------------------------------------------------------------------
Statement of Operations

For the
Year Ended
Dec. 31,
- ------------------------------------------------------------------------------
1996
Investment Income (Note 1):
Dividends $14,802,988
Interest 971,287
Less: Foreign taxes withheld (148,592)
-----------
Total income 15,625,683
-----------
Expenses:
Investment advisory fee (Note 2) 3,562,609
Distribution fee (Note 2) 1,559,921
Transfer agent fee (Note 2) 623,604
Printing and postage 191,642
Accounting fee (Note 2) 117,160
Legal 105,286
Custodian fees 67,181
Miscellaneous 55,576
Audit 49,511
Director's fees 36,330
Insurance 17,258
Registration fees 16,940
-----------
Total expenses 6,403,018
-----------
Net investment income 9,222,665
-----------

Realized and unrealized gain on investments:
Net realized gain from security transactions 44,618,521
Change in unrealized appreciation or
depreciation of investments 13,950,633
-----------
Net gain on investments 58,569,154
-----------

Net increase in net assets resulting from operations $67,791,819
===========

See Notes to Financial Statements.

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND
- --------------------------------------------------------------------------------
Statement of Changes in Net Assets

For the Year Ended Dec. 31,
- --------------------------------------------------------------------------------
1996 1995
Increase in Net Assets:
Operations:
Net investment income $ 9,222,665 $ 14,026,672
Net realized gain from security transactions 44,618,521 35,372,071
Change in unrealized appreciation or
depreciation of investments 13,950,633 93,655,306
------------ ------------
Net increase in net assets resulting
from operations 67,791,819 143,054,049
------------ ------------
Distributions to Shareholders from:
Net investment income:
Class A Shares (8,654,688) (13,188,618)
Class B Shares (157,647) (71,352)
Class D Shares (410,330) (766,702)
Net realized short-term gains:
Class A Shares (3,437,642) (594,281)
Class B Shares (118,740) (6,947)
Class D Shares (187,069) (39,689)
Net realized long-term gains:
Class A Shares (26,060,648) (31,183,490)
Class B Shares (896,656) (411,017)
Class D Shares (1,420,532) (2,033,414)
------------ ------------
Total distributions (41,343,952) (48,295,510)
------------ ------------
Capital Share Transactions (Note 3):
Proceeds from sale of shares 36,388,229 35,420,420
Value of shares issued in reinvestment
of dividends 33,751,356 40,313,196
Cost of shares repurchased (77,258,035) (106,718,217)
------------ ------------
Decrease in net assets derived from
capital share transactions (7,118,450) (30,984,601)
------------ ------------
Total increase in net assets 19,329,417 63,773,938

Net Assets:
Beginning of year 531,274,925 467,500,987
------------ ------------
End of year $550,604,342 $ 531,274,925
------------ ------------

See Notes to Financial Statements.

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND
- -------------------------------------------------------------------------------
Financial Highlights -- Class A Shares
(For a share outstanding throughout each year)(1)

For the Year Ended
Dec. 31, For the Year Ended Dec. 31,
- ------------------------------------------------------------------------------------------------------------------------------
1996 1995 1994 1993 1992
<S> <C>
Per Share Operating Performance:
Net asset value at beginning of year $ 14.87 $ 12.30 $ 13.70 $ 12.20 $ 11.28
------- ------- ------- ------- -------
Income from Investment Operations:
Net investment income 0.27 0.40 0.41 0.42 0.42
Net realized and unrealized gain/(loss)
on investments 1.67 3.58 (1.27) 1.78 0.93
------- ------- ------- ------- -------
Total from Investment Operations 1.94 3.98 (0.86) 2.20 1.35
------- ------- ------- ------- -------
Less Distributions:
Distributions from net investment income
and net realized short-term gains (0.38) (0.41) (0.44) (0.42) (0.42)
Distributions from net realized
long-term gains (0.84) (1.00) (0.10) (0.28) (0.01)
------- ------- ------- ------- -------
Total distributions (1.22) (1.41) (0.54) (0.70) (0.43)
------- ------- ------- ------- -------
Net asset value at end of year $ 15.59 $ 14.87 $ 12.30 $ 13.70 $ 12.20
======= ======= ======= ======= =======
Total Return(2) 13.46% 33.44% (6.32)% 18.12% 12.35%
Ratios to Average Daily Net Assets:
Expenses(3) 1.14% 0.93% 0.92% 0.92% 0.92%
Net investment income(4) 1.74% 2.85% 3.14% 3.12% 3.81%
Supplemental Data:
Net assets at end of year (000) $505,371 $492,454 $435,805 $469,163 $307,641
Portfolio turnover rate 20% 24% 23% 14% 6%
Average commissions per share $ 0.07(5) -- -- -- --

</TABLE>
- -----------------
(1) Computed based upon average shares outstanding.
(2) Total return excludes the effect of sales charge.
(3) Without the waiver of advisory fees (Note 2), the ratio of expenses to
average daily net assets would have been 0.99%, 0.99%, 0.98% and 1.07% for
the years ended December 31, 1995, 1994, 1993 and 1992, respectively.
(4) Without the waiver of advisory fees (Note 2), the ratio of net investment
income to average daily net assets would have been 2.79%, 3.07%, 3.06% and
3.66% for the years ended December 31, 1995, 1994, 1993 and 1992,
respectively.
(5) Disclosure is required for fiscal years beginning after September 1, 1995.
Represents average commission rate per share charged to the Fund on
purchases and sales of investments during the period.

See Notes to Financial Statements.

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND
- --------------------------------------------------------------------------------
Financial Highlights -- Class B Shares
(For a share outstanding throughout each period)(1)
For the Period
For the Year Jan. 3, 1995(2)
Ended through
Dec. 31, Dec. 31,
- --------------------------------------------------------------------------------
1996 1995
Per Share Operating Performance:
Net asset value at beginning of period $ 14.83 $12.28
------- ------
Income from Investment Operations:
Net investment income 0.19 0.30
Net realized and unrealized gain
on investments 1.63 3.56
------- ------
Total from Investment Operations 1.82 3.86
------- ------
Less Distributions:
Distributions from net investment
income and net realized
short-term gains (0.30) (0.31)
Distributions from net realized
long-term gains (0.84) (1.00)
------- ------
Total distributions (1.14) (1.31)
------- ------
Net asset value at end of period $ 15.51 $14.83
======= ======
Total Return(3) 12.60% 32.42%
Ratios to Average Daily Net Assets:
Expenses(4) 1.92% 1.70%(6)
Net investment income(5) 0.95% 2.13%(6)
Supplemental Data:
Net assets at end of period (000) $17,661 $7,504
Portfolio turnover rate 20% 24%
Average commissions per share $ 0.07(7) --
- -----------------
(1) Computed based upon average shares outstanding.

(2) Commencement of operations.

(3) Total return excludes the effect of sales charge.

(4) Without the waiver of advisory fees (Note 2), the ratio of expenses to
average daily net assets would have been 1.74% (annualized) for the period
ended December 31, 1995.

(5) Without the waiver of advisory fees (Note 2), the ratio of net investment
income to average daily net assets would have been 2.09% (annualized) for
the period ended December 31, 1995.

(6) Annualized.

(7) Disclosure is required for fiscal years beginning after September 1, 1995.
Represents average commission rate per share charged to the Fund on
purchases and sales of investments during the period.

See Notes to Financial Statements.

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND

<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------
Financial Highlights -- Class D Shares
(For a share outstanding throughout each period)(1)
For the Period
Apr. 6, 1993(2)
through
For the Year Ended Dec. 31, Dec. 31,
- --------------------------------------------------------------------------------------
<S> <C>
1996 1995 1994 1993
Per Share Operating Performance:
Net asset value at beginning of period $ 14.87 $ 12.30 $ 13.67 $ 13.21
------- ------- ------- -------
Income from Investment Operations:
Net investment income 0.22 0.34 0.37 0.25
Net realized and unrealized gain/(loss)
on investments 1.67 3.58 (1.20) 0.80
------- ------- ------- -------
Total from Investment Operations 1.89 3.92 (0.83) 1.05
------- ------- ------- -------
Less Distributions:
Distributions from net investment
income and net realized
short-term gains (0.33) (0.35) (0.42) (0.31)
Distributions in excess of net
investment income -- -- (0.02) --
Distributions from net realized
long-term gains (0.84) (1.00) (0.10) (0.28)
------- ------- ------- -------
Total distributions (1.17) (1.35) (0.54) (0.59)
------- ------- ------- -------
Net asset value at end of period $ 15.59 $ 14.87 $ 12.30 $ 13.67
======= ======= ======= =======

Total Return(3) 13.00% 32.91% (6.13)% 8.01%
Ratios to Average Daily Net Assets:
Expenses(4) 1.49% 1.28% 1.27% 1.27%(6)
Net investment income(5) 1.40% 2.50% 2.81% 2.73%(6)
Supplemental Data:
Net assets at end of period (000) $27,573 $31,317 $31,696 $23,481
Portfolio turnover rate 20% 24% 23% 14%
Average commissions per share $ 0.07(7) -- -- --

</TABLE>

- ----------------
(1) Computed based upon average shares outstanding.

(2) Commencement of operations.

(3) Total return excludes the effect of sales charge.

(4) Without the waiver of advisory fees (Note 2), the ratio of expenses to
average daily net assets would have been 1.34%, 1.34% and 1.31% for the
years ended December 31, 1995, 1994 and the period ended December 31, 1993,
respectively.

(5) Without the waiver of advisory fees (Note 2), the ratio of net investment
income to average daily net assets would have been 2.44%, 2.74% and 1.98%
for the years ended December 31, 1995, 1994 and the period ended December
31, 1993, respectively.

(6) Annualized.

See Notes to Financial Statements.

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND
- -------------------------------------------------------------------------------
Notes to Financial Statements

NOTE 1--Significant Accounting Policies

Flag Investors Telephone Income Fund, Inc. ("the Fund") is organized as a
Maryland corporation and commenced operations on January 18, 1984 (the exchange
date) when investors received five shares of the Fund in a tax-free exchange for
each share of American Telephone & Telegraph Company (AT&T), with rights to the
divested Bell regional operating companies attached. The Fund is registered
under the Investment Company Act of 1940, as amended, as an open-end, management
investment company. On April 6, 1993, the Fund began offering Class D Shares.
The Class A and Class D Shares each have different sales charges and
distribution fees. As of November 18, 1994, Class D Shares were no longer
available for sale; however, existing shareholders may reinvest their dividends.
On January 3, 1995, the Fund began offering Class B Shares, which have no
initial sales charge but are subject to a contingent deferred sales charge on
certain shares redeemed within six years of purchase.

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates. Significant
accounting policies are as follows:

A. Security Valuation--Portfolio securities that are primarily traded on a
recognized U.S. securities exchange are valued on the basis of their
last sale price. In the event that there are no sales or the security is
not listed, it is valued at the average between the last reported bid
and asked prices or at the fair value as determined by the Investment
Advisor under procedures established and monitored by the Board of
Directors. Short-term obligations with maturities of 60 days or less are
valued at amortized cost.

B. Repurchase Agreements--The Fund may agree to enter into tri-party
repurchase agreements. Securities held as collateral for tri-party
repurchase agreements are maintained by the broker's custodial bank in a
segregated account until maturity of the repurchase agreement. The
agreement ensures that the market value of the collateral, including
accrued interest thereon, is sufficient in the event of default. If the
counterparty defaults and the value of the collateral declines or if the

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND
- -------------------------------------------------------------------------------

NOTE 1--concluded

counterparty enters into an insolvency proceeding, realization of the
collateral by the Fund may be delayed or limited.

C. Federal Income Tax -- No provision is made for federal income taxes as
it is the Fund's intention to continue to qualify as a regulated
investment company and to make requisite distributions to shareholders
that will be sufficient to relieve it from all or substantially all
federal income and excise taxes. The Fund's policy is to distribute to
shareholders substantially all of its taxable net investment income and
net realized capital gains, if any.

Distributions are determined in accordance with income tax regulations,
which may differ from generally accepted accounting principles.
Accordingly, periodic reclassifications are made within the Fund's
capital accounts to reflect income and gains available for distribution
under income tax regulations.

D. Other -- Security transactions are accounted for on the trade date, and
the cost of investments sold is determined by use of the specific
identification method for both financial reporting and income tax
purposes. Cost for financial reporting purposes includes the value of
the securities received in the exchange. For income tax purposes, the
tax cost is the basis of the AT&T shares in the hands of the exchanging
AT&T shareholders at the date of exchange. Interest income is recorded
on an accrual basis. Dividend income is recorded on the ex-dividend
date.

NOTE 2--Investment Advisory Fees, Transactions with Affiliates and Other Fees

Investment Company Capital Corp. ("ICC"), a subsidiary of Alex. Brown
Financial Corp., is the Fund's investment advisor and Alex. Brown Investment
Management ("ABIM") is the Fund's sub-advisor. As compensation for its advisory
services, ICC receives from the Fund an annual fee, calculated daily and paid
monthly, at the following annual rates based upon the Fund's average daily net
assets: 0.85% of the first $100 million, 0.75% of the next $100 million, 0.70%
of the next $100 million, 0.65% of the next $200 million, 0.58% of the next $500
million, 0.53% of the next $500 million and 0.50% of that portion in excess of
$1.5 billion. Prior to April 11, 1996, the annual rates based upon the Fund's
average daily net assets were: 0.65% of the first $100 million, 0.55% of the
next $100 million, 0.50% of the next $100 million and 0.45% of that portion in
excess of $300 million.

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND
- --------------------------------------------------------------------------------
Notes to Financial Statements (continued)

NOTE 2--concluded

As compensation for its sub-advisory services, ABIM receives a fee from
ICC, payable from its advisory fee, calculated daily and paid monthly, at the
following annual rates based upon the Fund's average daily net assets: 0.60% of
the first $100 million, 0.55% of the next $100 million, 0.50% of the next $100
million, 0.45% of the next $200 million, 0.40% of the next $500 million, 0.37%
of the next $500 million and 0.35% of that portion in excess of $1.5 billion.

As compensation for its accounting services, ICC receives from the Fund an
annual fee, calculated daily and paid monthly, based upon the Fund's average
daily net assets. ICC received $117,160 for accounting services for the year
ended December 31, 1996.

As compensation for its transfer agent services, ICC receives from the Fund
a per account fee, calculated and paid monthly. ICC received $623,604 for
transfer agent services for the year ended December 31, 1996.

As compensation for providing distribution services, Alex. Brown & Sons
Incorporated ("Alex. Brown") receives from the Fund an annual fee, calculated
daily and paid monthly, at an annual rate equal to 0.25% of the Fund's average
daily net assets of Class A Shares, 1.00% (includes 0.25% shareholder servicing
fee) of the average daily net assets of Class B Shares and 0.60% of the average
daily net assets of Class D Shares. For the year ended December 31, 1996,
distribution fees aggregated $1,559,921 of which $1,251,568, $131,771 and
$176,582 were attributable to Class A Shares, Class B Shares and Class D Shares,
respectively. Alex. Brown received $7,000 of commissions on security
transactions from the Fund for the year ended December 31, 1996.

The Fund complex of which the Fund is a part has adopted a retirement plan
for eligible Directors. The actuarially computed pension expense allocated to
the Fund for the period January 1, 1996 through December 31, 1996 was
approximately $19,997, and the accrued liability was approximately $68,940.

NOTE 3--Capital Share Transactions

The Fund is authorized to issue up to 70 million shares of $.001 par value
capital stock (60 million Class A Shares, 5 million Class B Shares, 3 million
Class D Shares and 2 million undesignated). Transactions in shares of the Fund
are listed on the following pages.

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND
- --------------------------------------------------------------------------------
NOTE 3--continued

Class A Shares
-------------------------------
For the For the
Year Ended Year Ended
Dec. 31, 1996 Dec. 31, 1995
-------------- --------------
Shares sold 1,730,953 2,145,785
Shares issued to shareholders on
reinvestment of dividends 2,022,300 2,674,624
Shares redeemed (4,451,593) (7,132,553)
-------------- --------------
Net decrease in shares outstanding (698,340) (2,312,144)
============== ==============
Proceeds from sale of shares $ 26,738,906 $ 28,720,184
Value of reinvested dividends 30,812,547 37,305,866
Cost of shares redeemed (69,090,064) (97,427,131)
-------------- --------------
Net decrease from capital share transactions $(11,538,611) $(31,401,081)
============== ==============

Class B Shares
-------------------------------
For the Period
For the Jan. 3, 1995*
Year Ended through
Dec. 31, 1996 Dec. 31, 1995
-------------- --------------
Shares sold 628,129 489,011
Shares issued to shareholders on
reinvestment of dividends 73,229 32,826
Shares redeemed (68,656) (15,929)
-------------- --------------
Net increase in shares outstanding 632,702 505,908
============== ==============
Proceeds from sale of shares $ 9,649,323 $6,700,236
Value of reinvested dividends 1,109,830 458,760
Cost of shares redeemed (1,071,919) (229,177)
-------------- --------------
Net increase from capital share transactions $ 9,687,234 $6,929,819
============== ==============

- --------------
*Commencement of operations.

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND
- -------------------------------------------------------------------------------
Notes to Financial Statements (concluded)

NOTE 3--concluded

Class D Shares
-------------------------------
For the For the
Year Ended Year Ended
Dec. 31, 1996 Dec. 31, 1995
-------------- --------------
Shares sold -- --
Shares issued to shareholders on
reinvestment of dividends 120,074 183,832
Shares redeemed (456,901) (655,092)
-------------- --------------
Net decrease in shares outstanding (336,827) (471,260)
============== ==============
Proceeds from sale of shares $ -- $ --
Value of reinvested dividends 1,828,979 2,548,570
Cost of shares redeemed (7,096,052) (9,061,909)
-------------- --------------
Net decrease from capital share transactions $(5,267,073) $(6,513,339)
============== ==============

NOTE 4--Investment Transactions

Purchases and sales of investment securities, other than short-term and
U.S. government obligations, aggregated $105,864,301 and $146,174,704,
respectively, for the year ended December 31, 1996. There were no purchases or
sales of U.S. government obligations for the period.

On December 31, 1996, net unrealized appreciation for all securities in
which there was an excess of value over tax cost was $197,074,059, of which
$210,460,413 related to appreciated securities and $13,386,354 related to
depreciated securities.

NOTE 5--Net Assets

On December 31, 1996, net assets consisted of:

Paid-in capital:
Class A Shares $302,803,079
Class B Shares 16,617,054
Class D Shares 23,659,797
Accumulated net realized gain from securities transactions 13,937,442
Unrealized appreciation of investments 193,586,970
------------
$550,604,342
============

<PAGE>

FLAG INVESTORS TELEPHONE INCOME FUND
- --------------------------------------------------------------------------------

Report of Independent Accountants

To the Shareholders and Directors of
Flag Investors Telephone Income Fund, Inc.

We have audited the accompanying statement of net assets of Flag Investors
Telephone Income Fund, Inc. as of December 31, 1996 and the related statement of
operations for the year then ended, the statement of changes in net assets for
each of the two years in the period then ended and the financial highlights for
each of the respective periods presented. These financial statements and
financial highlights are the responsibility of the Fund's management. Our
responsibility is to express an opinion on these financial statements and
financial highlights 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 and financial
highlights are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. Our procedures included confirmation of investments owned as of
December 31, 1996 by correspondence with the custodian and brokers. 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 and financial highlights referred
to above present fairly, in all material respects, the financial position of
Flag Investors Telephone Income Fund, Inc. as of December 31, 1996, the results
of its operations for the year then ended, the changes in its net assets and its
financial highlights for each of the respective periods in conformity with
generally accepted accounting principles.

COOPERS & LYBRAND L.L.P.

Philadelphia, Pennsylvania
February 4, 1997

<PAGE>

APPENDIX A

CORPORATE BOND RATINGS

Standard & Poor's Bond Ratings

AAA -- The highest rating assigned by Standard & Poor's.
Capacity to pay interest and repay principal is extremely strong.

AA -- Very strong capacity to pay interest and repay principal
and differs from the higher rated issues only in small degree.

A -- Strong capacity to pay interest and repay principal
although it is somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than debt in higher rated categories.

BBB -- Regarded as having an adequate capacity to pay interest
and repay principal. Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
debt in this category than in higher rated categories.

BB, B, CCC, CC and C -- Regarded as having predominantly
speculative characteristics with respect to capacity to pay interest and repay
principal. BB indicates the least degree of speculation and C the highest
degree of speculation. While such debt will likely have some quality and
protective characteristics, these are outweighed by large uncertainties or
major exposures to adverse conditions.

CI -- Reserved for income bonds on which no interest is being
paid.

D -- In payment default. The D rating category is used when
interest payments or principal payments are not made on the date due even if
the applicable grace period has not expired, unless S&P believes that such
payments will be made during such grace period. The D rating also will be used
upon the filing of a bankruptcy petition if debt service payments are
jeopardized.

Moody's Bond Ratings

Aaa -- Judged to be of the best quality. Carries the smallest
degree of investment risk and generally referred to as "gilt edge." Interest
payments are protected by a large or exceptionally stable margin and principal
is secure. While the various protective elements are likely to change, such
changes as can be visualized are most unlikely to impair the fundamentally
strong position.

Aa -- Judged to be of high quality by all standards. Together
with the Aaa group, comprise what are generally known as high grade bonds.
Rated lower than the Aaa bonds because margins of protection may not be as
large as in the case of Aaa securities, or the fluctuation of protective
elements may be of greater amplitude or there may be other elements present
which make the long-term risks appear somewhat larger than in Aaa securities.

A -- Possess many favorable investment attributes and
considered upper medium grade obligations. Factors giving security to
principal and interest are considered adequate, but elements may be present
that suggest a susceptibility to impairment some time in the future.

A-1

<PAGE>

Baa -- Considered as medium grade obligations, that is, neither
highly protected nor poorly secured. Interest payments and principal security
appear adequate for the present but certain protective elements may be lacking
or may be characteristically unreliable over any great length of time. Lack
outstanding investment characteristics and in fact have speculative
characteristics as well.

Ba -- Judged to have speculative elements; future cannot be
considered as well-assured. Often the protection of interest and principal
payments may be very moderate and thereby not well safeguarded during both
good and bad times over the future. Uncertainty of position characterizes
bonds in this class.

B -- Generally lack characteristics of the desirable
investment. Assurance of interest and principal payments or maintenance of
other terms of the contract over any long period of time may be small.

Caa -- Of poor standing. May be in default or there may be
present elements of danger with respect to principal or interest.

Ca -- Represent obligations that are speculative in a high
degree. Often in default or have other marked shortcomings.

C -- The lowest rated class of bonds. Can be regarded as having
extremely poor prospects of ever attaining any real investment standing.

A-2