20-F 1 y22706be20vf.htm FORM 20-F FORM 20-F
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 20-F
(Mark one)
     
o   REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934
OR
     
þ   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2005
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
OR
     
o   SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Date of event requiring this shell company report                     
If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act. Yes o No o
     
 
METAL STORM LIMITED
(Exact Name of Registrant as Specified in its Charter)
 
Australia
(Jurisdiction of Incorporation or Organization)
Level 34, Central Plaza One
345 Queen Street
Brisbane, QLD, 4000
Australia
(Address of principal executive offices)
 
Securities registered or to be registered pursuant to Section 12(b) of the Act:
None
Securities registered or to be registered pursuant to Section 12(g) of the Act:
Ordinary Shares
(Title of Class)
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:
None
 
     Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the date of the close of the period covered by the annual report.
521,970,978 Ordinary Shares
     Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o No þ
     If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. Yes o No þ
     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) for the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes   þ   No   o
     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o          Accelerated filer þ           Non-accelerated filer o
     Indicate by check mark which financial statement item the registrant has elected to follow. þ Item 17   o Item 18
     If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
 
 

 


 

Table of Contents
             
  Identity of Directors, Senior Management and Advisors     4  
 
           
  Offer Statistics and Expected Timetable     4  
 
           
  Key Information     4  
 
           
  Information on Metal Storm     13  
 
           
  Unresolved Staff Comments     21  
 
           
  Operating and Financial Review and Prospects     22  
 
           
  Directors, Senior Management and Employees     28  
 
           
  Major Shareholders and Related Party Transactions     34  
 
           
  Financial Information     34  
 
           
  The Offer and Listing     36  
 
           
  Additional Information     38  
 
           
  Quantitative and Qualitative Disclosure about Market Risk     49  
 
           
  Description of Securities Other than Equity Securities     49  
 
           
  Defaults, Dividend Arrearages and Delinquencies     50  
 
           
  Material Modifications to the Rights of Security Holders and the Use of Proceeds     50  
 
           
  Controls and Procedures     50  
 
           
  Audit Committee Financial Expert     51  
 
           
  Code of Ethics     51  
 
           
  Principal Accountant Fees and Services     51  
 
           
  Exemptions from the Listing Standards for Audit Committees     51  
 
           
  Purchases of Equity Securities by the Issuer and Affiliated Purchasers     52  
 
           
  Financial Statements     53  
 
           
  Financial Statements     53  
 
           
  Exhibits     53  
 EX-4.7: DEED OF TERMINATION AGREEMENT
 EX-4.10: CASH ADVANCE FACILITY AGREEMENT
 EX-8.0: LIST OF SUBSIDIARIES
 EX-12.1: CERTIFICATION
 EX-12.2: CERTIFICATION
 EX-13.1: CERTIFICATION
 EX-13.2: CERTIFICATION

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CURRENCY OF PRESENTATION AND EXCHANGE RATES
     All references herein to “A$” and “$” are to Australian dollars. All references herein to “US$” and “U.S. dollar” are to United States dollars. Except as otherwise stated, all monetary amounts in this annual report are presented in Australian dollars. When necessary, historic data were converted at the applicable rate for the date or year indicated. The exchange rate used to convert balance sheet accounts at December 31, 2005 was A$1.00 = US$0.7301.
     For your convenience, we have translated some Australian dollar amounts into U.S. dollar amounts at the noon buying rate in The City of New York for cable transfers in Australian dollars as certified for customs purposes by the Federal Reserve Bank of New York (the “noon buying rate”). On July 12, 2006, the noon buying rate for Australian dollars into U.S. dollars was A$1.00 =US$0.7536.
     The following table contains information for the noon buying rate for the Australian dollar into U.S. dollars for the periods indicated.
                                 
    At            
    Period   Average        
    End   Rate (1)   High   Low
Year ended December 31,
                               
2001
    0.5117       0.5127       0.5712       0.4828  
2002
    0.5625       0.5448       0.5748       0.5060  
2003
    0.7520       0.6589       0.7520       0.5629  
2004
    0.7805       0.7384       0.7979       0.6840  
2005
    0.7342       0.7620       0.7974       0.7261  
Period
                               
January 2006
    0.7572             0.7572       0.7379  
February 2006
    0.7430             0.7548       0.7363  
March 2006
    0.7165             0.7458       0.7056  
April 2006
    0.7593             0.7593       0.7177  
May 2006
    0.7519             0.7781       0.7509  
June 2006
    0.7423             0.7527       0.7284  
 
(1)   Determined by averaging noon buying rates on the last day of each full month during the period.
FORWARD-LOOKING STATEMENTS
     Certain statements in this annual report may constitute “forward-looking statements”. Such forward-looking statements are based on the beliefs of our management as well as assumptions based on information available to us. When used in this annual report, the words “anticipate”, “believe”, “estimate”, “project”, “intend” and “expect” and similar expressions, as they relate to us or our management, are intended to identify forward-looking statements. Such forward-looking statements reflect our current views with respect to future events and are subject to certain known and unknown risks, uncertainties and assumptions. Many factors could cause our actual results, performance or achievements to be materially different from any future results, performance or achievements that may be expressed or implied by such forward-looking statements. These include, but are not limited to, risks or uncertainties associated with the development of our technology, our ability to obtain government research and development grants, our ability to raise additional capital, our ability to protect our proprietary technology, the market for our products, government regulation in Australia and the United States, changes in tax and other laws, changes in competition, the loss of key personnel and other factors identified under Item 3D “Key Information – Risk Factors” of this annual report. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described in this annual report as anticipated, believed, estimated or expected. Accordingly, you should not place undue reliance on these forward-looking statements. These statements speak only as of the date of this annual report and shall not be revised or updated to reflect events after the date of this document.

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PART I
Item 1. Identity of Directors, Senior Management and Advisors
     Not applicable.
Item 2. Offer Statistics and Expected Timetable
     Not applicable.
Item 3. Key Information
A. Selected Financial Data
     The following table presents our selected financial information at the dates and for each of the years indicated. You should read the following information together with the information contained in Item 5 “Operating and Financial Review and Prospects”, as well as our financial statements and the related notes and other financial information appearing elsewhere in this annual report.
     Historically, we have prepared financial statements in Australian dollars and in accordance with Australian generally accepted accounting principles that existed at the time (“historical Australian GAAP”) in order to comply with requirements of the Australian Stock Exchange, which is our primary listing. In addition, we voluntarily prepared financial statements in U.S. dollars and in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) for inclusion in our annual report on Form 20-F.
     Commencing with fiscal years beginning on or after January 1, 2005, Australian companies such as Metal Storm must comply with Australian equivalents to International Reporting Standards (“A-IFRS”) as well as International Financial Reporting Standards (“IFRS”) and interpretations adopted by the International Accounting Standards Board. We believe that U.S. investors better understand IFRS than historical Australian GAAP and, as a result, we no longer prepare financial statements in accordance with U.S. GAAP, but provide reconciliations to U.S. GAAP permitted by Form 20-F.
     Our financial statements for 2005 have been prepared in Australian dollars and in accordance with A-IFRS and also comply with IFRS and interpretations adopted by the International Accounting Standards Board. For the purpose of comparability with 2005, the 2004 financial statements included in this annual report have been prepared on a basis to comply with A-IFRS and IFRS.
     Our selected financial data set forth below for 2005 and 2004 are presented in accordance with A-IFRS. The statement of operations data for the years ended December 31, 2005 and 2004 and the balance sheet data as at December 31, 2005 and 2004 have been derived from our audited financial statements, which are included elsewhere in this annual report.
                 
    As of and for the year ended  
    December 31,  
    2005     2004  
    A$     A$  
Income Statement data in accordance with A-IFRS:
               
Revenue
    830,645       837,201  
Expenses
    (10,755,679 )     (12,714,745 )
 
           
Loss from continuing operations
    (9,925,034 )     (11,877,544 )
Finance costs
    (35,496 )     (43,568 )
Income tax benefit
    648,320       332,744  
 
           
Loss after tax from continuing operations
    (9,312,210 )     (11,588,368 )
Loss after tax from discontinued operation
    (1,602,390 )     (1,515,759 )
 
           
Loss attributable to members of the parent
    (10,914,600 )     (13,104,127 )
 
           
Basic and diluted loss per share(1)
    (0.0209 )     (0.0262 )
Weighted average ordinary number of shares outstanding
    521,970,978       500,886,725  
Income Statement data in accordance with U.S. GAAP:
               
Revenue
    230,743       42,636  
Loss attributable to members of the parent
    (12,016,844 )     (13,121,233 )
Basic and diluted loss per share
    (0.0220 )     (0.0262 )
Balance Sheet data in accordance with A-IFRS:
               
Total current assets
    7,137,322       17,349,971  
Total assets
    7,429,721       20,327,317  
Total current liabilities
    1,564,696       3,507,365  
Total liabilities
    1,649,859       4,127,324  
Contributed equity
    56,559,039       56,559,039  
Total equity
    5,779,862       16,199,993  

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    As of and for the year ended  
    December 31,  
    2005     2004  
    A$     A$  
Balance Sheet data in accordance with U.S. GAAP:
               
Total assets
    7,102,472       20,627,396  
Total equity
    5,151,734       16,674,109  
Other Financial Data:
               
Dividends per share
           
 
(1)   Net loss per ordinary share — basic and diluted is calculated as net loss for the period divided by adjusted weighted average number of ordinary shares outstanding for the same period.
     Our selected financial data set forth below for 2003, 2002 and 2001 are presented in Australian dollars and in accordance with U.S. GAAP. The statement of operations data for the years ended December 31, 2003, 2002 and 2001 and the balance sheet data as at December 31, 2003, 2002 and 2001 have been derived from our audited financial statements.
                         
    As of and for the year ended December 31,  
    2003     2002     2001  
    A$     A$     A$  
Amounts in accordance with U.S. GAAP Statement of Operations data:
                       
Total operating income
    348,570       22,711       688,863  
Total operating expenses
    (8,153,088 )     (9,949,420 )     (6,423,033 )
 
                 
Loss from operations
    (7,804,518 )     (9,926,709 )     (5,734,170 )
Total other income
    997,985       52,272       564,765  
 
                   
Loss after tax from discontinued operations
    (373,244 )            
 
                 
Net loss
    (7,179,777 )     (9,874,437 )     (5,169,405 )
 
                 
Net loss per ordinary share — basic and diluted (1)
    (0.016 )     (0.023 )     (0.012 )
Weighted average ordinary number of shares outstanding
    442,525,034       428,974,260       422,326,884  
Balance Sheet data:
                       
Total current assets
    9,451,860       8,661,303       6,669,488  
Total current liabilities
    4,100,085       2,184,357       454,079  
Total assets
    15,101,660       8,825,556       6,892,701  
Ordinary share capital
    31,506,515       29,615,104       22,801,980  
Total stockholders’ equity
    9,353,392       6,578,228       6,378,059  
Other financial data:
                       
Dividends per share
                 
 
(1)   Net loss per ordinary share — basic and diluted is calculated as net loss for the period divided by adjusted weighted average number of ordinary shares outstanding for the same period.
B.   Capitalization and Indebtedness
     Not applicable.
C. Reasons for Offer and Use of Proceeds
     Not applicable.
D. Risk Factors
There is uncertainty regarding Metal Storm continuing as a going concern.
     In order to meet Metal Storm’s objectives to develop, manufacture and market commercial products effectively, we will require additional funding until such time that product sales are of sufficient volume to generate positive cash flows from operations. This has taken longer and has cost more than originally anticipated. Based on the expected levels of operating expenditures, in order to continue its operations, Metal Storm will require additional sources of capital. While Metal Storm has previously been successful in raising additional capital, there can be no assurance that we will be able to raise sufficient capital to continue our operations. If we are unsuccessful in our efforts to obtain sufficient financing to continue to fund our current operations, we will be required to significantly reduce or cease operations altogether. Accordingly, there exists a substantial doubt about Metal Storm’s ability to continue as a going concern.

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     Our directors believe that Metal Storm will succeed in securing additional funding in the near future. In June 2006, Metal Storm signed an agreement with Harmony Investment Fund Limited to establish a A$5 million short-term working capital loan facility. Metal Storm has also signed a preliminary agreement with Harmony Capital Partners to facilitate and sub-underwrite a Renounceable Rights Offer of A$27.5 million in unsecured Convertible Notes with attaching Options that is being offered to shareholders resident in Australia and New Zealand. The Renounceable Rights Offer is anticipated to commence in late July 2006 and close in August 2006 and is subject to certain conditions. There can be no assurance, however, that this financing transaction will occur or that the final terms will be substantially the same as the terms of the preliminary agreement.
     If such funding were to be unavailable, there would be significant uncertainty as to whether Metal Storm would continue as a going concern and, therefore we may realize the value of our assets and settle our liabilities at amounts different from those stated in our financial statements. No adjustments have been made to the financial statements relating to the recoverability and classification of the asset carrying amounts or classification of liabilities that might be necessary should Metal Storm not continue as a going concern.
We will need additional capital and may not be able to raise additional capital on favorable terms, if at all.
     We may not have commercialized our technology when existing funds have been fully expended. Metal Storm will likely require additional capital by late November 2006 to fund product development programs. In addition, we cannot be certain that we will not seek to exploit business opportunities that will require us to raise additional capital from equity or debt sources. In particular, developing and commercializing new technology and products to develop our business could require a significant commitment of additional resources that could, in turn, require us to obtain additional funding. We may also require further funds to pursue regulatory clearances, prosecute and defend our intellectual property rights, develop marketing capabilities and fund operating expenses.
     Our ability to obtain additional financing will be subject to a number of factors, including market conditions and our operating performance. These factors may render the timing, amount, terms and conditions of additional financing unattractive for us. The sale of additional equity or convertible debt securities would result in dilution to our existing stockholders. Additional debt could result in increased expenses and could result in covenants that would restrict our operations. We cannot be certain that we will be able to raise any required funding or capital on favorable terms or at all. If we are unable to obtain such additional funding or capital when needed, we may be required to reduce the scope of our anticipated plans, including our research and development activities, which could materially adversely affect our business, financial condition and results of operations.
     We have incurred operating losses in each year since our inception. We had net losses of A$10.9 million and A$13.1 million for the years ended December 31, 2005 and 2004, respectively. We expect to incur additional operating losses over the next several years. Our profitability is dependent on our ability, alone or with others, to complete the successful product engineering of our technology, obtain any required regulatory clearances, and commercialize our products. We cannot be certain if or when we will achieve profitability.
We are in the product engineering phase and do not yet have any product for sale based on our core technology.
     Most of our technology requires further investment, research, development, testing and possibly regulatory approval prior to any commercial sales. Metal Storm does not currently derive any revenue from the commercial sale of any applications of our technology. We cannot be sure of the extent to which the technology or any products we develop will be able to penetrate the potential markets for defense or commercial applications or gain market acceptance.
We cannot be certain of market acceptance of our technology or the rate of any market acceptance.
     We plan to develop our technology for use in a range of military, law enforcement, counter-terrorism and commercial applications. It is not yet known whether our technology will be accepted in the market for any of these applications or the rate of any market acceptance. The degree of market acceptance will depend on a number of factors, including the receipt and timing of any regulatory approvals, the establishment and demonstration of the need, safety, efficacy and cost-effectiveness of our technology and products, and our technology’s advantages over existing technologies. It is not yet known whether we will be able to fully develop or commercialize our technology and products, even if they perform successfully in research and evaluation trials.
We are dependent on retaining key personnel.
     There is competition among defense development companies for qualified technical employees and retaining and attracting qualified individuals is critical to our success. The responsibility of overseeing day to day management and the strategic management of Metal Storm is concentrated amongst a small number of key people including the Board and senior management. The loss of the services of certain such personnel could have a material adverse effect upon Metal Storm, as we may not be able to recruit replacements for the key personnel within a short timeframe.

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Any catastrophic event involving our technology could adversely affect Metal Storm’s reputation.
     Any catastrophic accident involving the testing of our technology or the use of products that are developed utilizing our technology could severely damage Metal Storm’s reputation, marketing ability and results of operations.
We work on research and development programs.
     Some of our technology applications progress in collaboration with U.S. and Australian government defense research and development program support. We have obtained such support from both the U.S. and Australian governments. We have entered into agreements with various agencies that provide conditions to the funding of research and development programs. For example, generally we are required to achieve certain milestones with respect to the development of our technology prior to receiving payment under the agreements. In addition, we have granted exclusive licensing rights under certain agreements and we are also in some circumstances required to repay money received under the agreements. Further, although the Australian programs provided for funding contributions by consortium members, we have received no direct funds from these programs. If Metal Storm is unable to continue existing research and development programs or to enter into new research and development programs, if there is a decrease of available funding in respect of such programs, or if the U.S. or Australian governments choose to exercise powers available to them under export control regulations to control the export of Metal Storm technology or products developed from it, this could have a material adverse affect on us.
There are some limitations relating to our technology.
     In its usual configuration, the Metal Storm technology stacks a number of projectiles in each barrel with propellant or gunpowder located in a space that separates the projectiles. The propellant is electronically initiated using inductive coils. Unlike conventional gun systems, which are mechanical in operation, our technology is reliant on a 100% electronic fire control system. Electronic systems may be adversely affected by electromagnetic interference. Failure to design the electronics systems to minimize susceptibility to natural or man-made electromagnetic interference may result in unplanned and potentially catastrophic failure of our technology.
     We may not have adequate protection for our intellectual property.
     We principally rely upon patents, trade secret, copyright and contract law to protect our proprietary technology. We cannot be certain that any protective measures we have taken will be adequate to protect our proprietary technology. Many of the laws of foreign countries treat the protection of proprietary rights differently from, and may not protect our proprietary rights to the same extent as do, laws in Australia, the United States and Patent Co-operation Treaty countries. In addition, the laws of many countries, including Australia and the United States, provide governments with the ability to control or restrict the use of defense technologies.
     Patent matters involve complex legal and factual questions. Accordingly, we cannot predict the availability and breadth of claims sought in relation to patents. Statutory differences in patentable subject matter may limit the protection we can obtain for some of our inventions, or prevent us from obtaining patent protection, which could materially adversely affect our business, financial condition and results of operations.
     Additionally, the enforceability of a patent is dependent on a number of factors, which may vary between jurisdictions. These factors may include the novelty of the invention, the requirement that the invention not be obvious in light of prior art, including prior use or publication of the invention, the utility of the invention and the extent to which the patent clearly describes the best method of working the invention.
     While we have obtained and continue to seek patent protection for our technology, we cannot be certain that:
    any of the pending or future patent applications filed by us or on our behalf will be approved;
 
    we will develop any additional proprietary products or processes that are patentable; or
 
    third parties will not independently develop similar products or processes, duplicate any of the products or processes we have or are developing relating to our technology, or design around the patents we own with competitive advantages.

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     Furthermore, we cannot be certain that patents held by third parties will not prevent the commercialization of products incorporating our technology or that third parties will not challenge or seek to narrow, invalidate or circumvent any of our issued, pending, or future patents.
     Protecting our proprietary technology from infringement by others may affect our business.
     We may need to engage in litigation to enforce patents, or to determine the scope and validity of third party proprietary rights. This could result in substantial costs to us and divert efforts from our business. We may have to participate in opposition proceedings before the Australian Patent Office or a foreign patent office, or in interference proceedings declared by the U.S. Patent and Trademark Office, to determine priority of invention of patent applications filed by competitors. Any such litigation, interference or opposition proceeding, regardless of the outcome, could be expensive and time consuming and adverse determinations in any such proceedings could prevent us from developing, manufacturing or commercializing our technology or products, which could have a material adverse effect on our business, financial condition and results of operations.
     In addition to patent protection, we rely on unpatented trade secrets, know-how and proprietary technological innovation and expertise, which are protected, in part, by confidentiality agreements with our employees, advisers and consultants. We cannot be certain that these agreements will not be breached, that we will have adequate remedies for any breach, or that our unpatented proprietary intellectual property will not otherwise become known or independently discovered by competitors. We also cannot be certain that relevant inventions will not be developed by persons not bound by such agreements.
     We may be subject to patent infringement claims from our competitors and other third parties.
     Our commercial success may depend, in part, on our ability to avoid infringing on patents issued to others. Although we are not aware of any action or threatened action alleging patent infringement or improper use of proprietary information by us, if we have to defend any such claims we could incur substantial costs and our management resources could be diverted. This could have a material adverse effect on our business, financial condition and results of operations.
     If we were found to be infringing any third party patents, we could be required to pay damages, alter our products or processes, obtain licenses or cease certain activities. We cannot be certain that if we required licenses for patents held by third parties that they would be made available on terms acceptable to us, if at all. To the extent that we required such licenses for the development of our technology and we were unable to obtain them, we could be foreclosed from the development, manufacture or commercialization of technology or products requiring such licenses, or encounter delays in product introductions while attempting to design around such patents. This could have a material adverse effect on our business, financial condition and results of operations.
     The Australian and U.S. governments may take action on patent applications and patents.
     Under the provisions of the Australian Patents Act, the Commonwealth of Australia has the right to exploit, or authorize others in writing to exploit, an invention for the services of the Commonwealth of Australia at any time after a patent application has been made. The remuneration and terms for exploitation are determined by agreement between the person entitled to the benefit of the patent application, or the person’s nominee, and the Commonwealth of Australia. If there is no agreement, the determination is made by a prescribed court.
     Under the provisions of the Australian Patents Act, a patent or a patent application may also be acquired by the Commonwealth of Australia. In that instance, all rights in the patent, or the patent application, vest in the Commonwealth of Australia. Compensation must be paid in an amount to be agreed between the person entitled to be compensated, and the Commonwealth of Australia. If there is no agreement, the amount of compensation is determined by a prescribed court. As such an acquisition clearly involves an acquisition of property, the terms of that acquisition must be “just”, within the meaning of the Australian Constitution.
     The Australian Patents Act also allows the Commissioner of Patents, on the direction of the relevant Minister of the Commonwealth of Australia, to prohibit or restrict the publication of information about the subject matter of a patent application. While any such order is in force, the complete specification of the application is not open to public inspection, acceptance must not be notified and a patent must not subsequently be granted. As a result, if the Commonwealth of Australia were to take action on one or more of our patents under the Australian Patents Act, we may not be able to exclusively commercially exploit such patents in the way we currently intend. Additionally, the compensation we receive in connection with such actions may be significantly less than what we would receive if we were to retain full rights to the patent.
     Under the U.S. Patent Act, the U.S. government may use an invention described in and covered by a U.S. patent without license of the owner. Where this occurs, the owner’s only remedy is an action against the U.S. government for the recovery of reasonable and entire compensation for the use and manufacture of the invention.

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     Under the U.S. Patent Act, if one of the authorized offices of various government agencies identified under the Act holds the opinion that publication or disclosure of an invention described in a patent application would be detrimental to the national security, the Commissioner of Patents being so notified shall order that the invention be kept secret and also withhold the publication of the application or the grant of a patent for such period as the national interest requires. The owner of an application that has been placed under a secrecy order shall have the right to appeal from the order to the Secretary of Commerce. An applicant whose patent is withheld shall have the right to apply for compensation for the damage caused by the order of secrecy.
     It is also possible that countries other than Australia or the United States could take action that may impact upon our patents and patent applications. Any actions on our patents by the governments of Australia, the United States or other countries could affect our ability to protect our technology and our ability to effectively commercialize our technology. This could have a material adverse effect on our business, financial condition and results of operations.
We have contracted to perform some systems integration work at a fixed price, which could turn out to be less than our costs.
     We perform systems integration work for third parties under contracts. Several of our contracts are bid on a fixed price basis. As such, there is inherent risk that our actual costs to perform the contracted job could exceed the agreed upon fixed price, which could have a material adverse effect on our business, financial condition and results of operations.
There are potential adverse effects from competition and technological changes.
     The defense industry market is highly competitive and can be subject to significant technological change. Large, well-established defense companies are engaged in research and development and have considerably greater resources than Metal Storm to develop applications for defense technology. We cannot be certain that our competitors will not succeed in developing technologies and products that are more effective than any which we are developing, or which would render our technology and products obsolete or non-competitive. Much of the research being conducted on defense technology is funded principally by government agencies in the United States. We compete with such other companies for government resources allocated to such research and development projects. There are existing defense companies that may have target markets similar to, if not the same as, ours. Such companies may be developing their own technology and products, which may ultimately compete with ours. This could have a material adverse effect on our business, results of operations and financial condition.
     The defense industry market is characterized by changing technology, evolving industry standards, introductions and enhancements and changing customer demands. These market characteristics are exacerbated by the nature of the defense industry. Accordingly, Metal Storm’s success may depend on our ability to adapt to changing technologies, our ability to adapt our technology to evolving industry standards, and to continually improve the performance, features and reliability of our technology, in response to both evolving demands of the marketplace and competitive product offerings. If we fail to adapt to such changes and evolution, this could have a material adverse effect on our business, results of operations and financial condition.
     There are existing companies who may have target markets similar to, if not the same as, ours. Such companies may be developing their own technology and products, which may ultimately compete with ours. Our technology may be perceived by our competitors as threatening existing markets and therefore may be resisted. As a result, we cannot be certain that we will be successful in commercializing our technology or that we will be able to penetrate the potential markets for our products.
There may be reductions or changes in military expenditures.
     We anticipate that our primary customers will be the U.S. and Australian governments, the agencies of the U.S. and Australian governments’ Departments of Defense, the U.S. Department of Justice and the global defense industry. Our markets may be limited by U.S. and Australian government requirements pertaining to foreign markets. We also cannot predict future levels of defense spending with certainty and declines in military expenditures could materially adversely affect our results of operations and financial condition. The impact of possible declines in the level of defense procurement on our results of operations and financial condition will depend upon the timing and size of the changes and our ability to mitigate their impact with new business, business consolidations or cost reductions. The loss or significant curtailment of a material program in which we participate could have a material adverse affect on our future results of operations and financial condition.
We are subject to government regulation.
     We are developing products for sale in the defense and law enforcement industries, which are subject to extensive regulation. This regulation may adversely affect our business. For example, products incorporating our technology are required to undergo rigorous testing as well as extensive regulatory approval processes. These processes take significant time and require us to expend substantial resources. Delays in obtaining regulatory approvals could adversely affect the development and commercialization of our technology and products and could have a material adverse effect on our business, financial condition or results of operations.

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     We will need to obtain operating licenses and permits. Such licenses and permits may be difficult to obtain and retain depending on government policies, customs, changes in political leadership, and other factors. We cannot assure you that we will continue to be in compliance with any such licenses or permits or any other governmental requirements. If we fail to comply with any such licenses or permits or any other governmental requirements it could have a material adverse effect on our business, financial condition and results of operations.
     Products to be manufactured using our technology may also be subject to government regulation, including regulations governing use, specification, manufacture, handling, disposal, packaging, labeling, transport and import/export in Australia, the United States and in each of the countries into which such products are intended to be exported. See Item 4B “Information on Metal Storm - Business Overview—Regulation” for a discussion of government regulations that we are subject to in Australia and the United States.
     Compliance with government regulation requires us to allocate resources to monitoring compliance, training, security of goods, reporting and reviewing legislative and other changes to ensure we are complying with the relevant regulations in the jurisdictions in which we operate. Failure to comply with government regulations could result in our inability to sell our products in those jurisdictions.
There are risks inherent in U.S. government contracts.
     We expect that a significant portion of our sales will be associated with long-term contracts and programs for the U.S. government in which there are significant inherent risks, including risks particular to the defense industry. The primary risks relate to:
    Contract Termination
     Any contracts we may enter into with the U.S. government may be subject to termination by it either for its convenience or in the event of a default by us as the contractor. Termination for convenience provisions may only provide for the recovery by us of costs incurred or committed, settlement expenses and profit on work completed prior to termination. Termination for default provisions may render us liable for excess costs incurred by the U.S. government in procuring undelivered items from another source.
    Loss of Appropriations
     U.S. government contracts are usually conditional upon the continuing availability of U.S. Congressional appropriations. Congress usually appropriates funds for a given program on a fiscal-year basis even though contract performance may take more than one year. Consequently, at the outset of a major program, the contract is usually partially funded, and additional monies are normally committed to the contract by the procuring agency only as appropriations are made by Congress for future fiscal years. In addition, most U.S. government contracts are subject to modification in the event of changes in funding. Any failure by Congress to appropriate additional funds to any program in which we participate or any contract modification as a result of funding changes could materially delay or terminate such program and therefore have a material adverse effect on our business, results of operations or financial condition.
    Procurement and Other Related Laws and Regulations
     If we enter into contracts with the U.S. government we may be subject to extensive and complex U.S. government procurement laws and regulations. These laws and regulations provide for ongoing U.S. government audits and reviews of contract procurement, performance and administration. Failure to comply, even inadvertently, with these laws and regulations and with laws governing the export of munitions and other controlled products and commodities, and any significant violations of any other U.S. federal law, could subject us to potential contract termination, civil and criminal penalties, and under certain circumstances, suspension and debarment from future U.S. government contracts for a specified period of time. Any such actions could have a material adverse effect on our business, results of operations or financial condition.
    Protection of Proprietary Technology
     If we enter into U.S. government contracts, and in particular contracts that involve modification or development of our technology or products, we may face a risk that the U.S. government would seek to assert far-reaching rights to our inventions and technology. Such assertions could compromise our competitive position.
    Changes and Adjustments
     The U.S. government often directs changes in contract work, particularly in the case of products under development. Recovery of additional costs and profit attributable to the changed work may require a protracted effort that could adversely affect our cash flow.

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    Competitive Bidding and Domestic Preferences
     We may need to obtain military contracts through either competitive bidding or sole-sourced procurement. We cannot be certain that we will be successful in having our bids accepted or, if accepted, that awarded contracts will be profitable. We may be disadvantaged in competing for contracts by laws and regulations that give preference to firms that offer products manufactured in the United States or to small or minority-owned businesses. We may also be disadvantaged by regulations limiting the access of non-U.S. citizens to classified information of the U.S. government or the use or storage of such information at facilities outside the United States. We have organized Metal Storm Inc., our U.S. subsidiary, as a U.S. owned “small business”, as defined by applicable U.S. Department of Defense requirements, which allows Metal Storm Inc. to contract directly with U.S. government and defense agencies in accordance with U.S. Department of Defense requirements. Our other U.S. subsidiary, Metal Storm U.S.A. Limited, is 100% owned by us and was formed to contract with both U.S. government agencies as well as non-government defense contractors.
     Additionally, inherent in either procurement process is the risk that if a bid is submitted and a contract is subsequently awarded, actual performance costs may exceed the projected costs upon which the submitted bid or contract price was based. To the extent that actual costs exceed the projected costs on which bids or contract prices were based, our potential profitability could be materially adversely affected.
We may have product liability exposure in the future.
          The testing, marketing and sale of our technology may result in products that are used in situations that may result in serious, permanent bodily injury, or even death, to those involved. A person injured in connection with the use of our products may bring legal action against us to recover damages on the basis of claims including personal injury, wrongful death, negligent design, dangerous product or inadequate warning. We may also be subject to lawsuits involving allegations of misuse of our products. If successful, personal injury, misuse and other claims could have a material adverse effect on our business, operating results and financial condition. There can be no assurance that adequate or necessary insurance coverage will be available or will be obtained to limit our product liability exposure.
We may be dependent on third party manufacturers, suppliers and teaming partners.
     We currently do not have any manufacturing capabilities. In the future, we may be required to enter into contracting arrangements with third party manufacturers in order to manufacture our products for large-scale, later-stage testing. If we need to use a third party to manufacture all, or a portion of, our products we cannot be certain that we will be able to enter into satisfactory arrangements with such contract manufacturers. If, at any time, we are unable to maintain or expand as necessary or contract for manufacturing on acceptable terms, our manufacturing capabilities and our ability to conduct tests with our products will be adversely affected, resulting in delays in submissions for regulatory approvals.
     We may also need to develop manufacturing resources, enter into collaborative arrangements with other parties who have established manufacturing capabilities, or have third parties manufacture our products on a contractual basis. We cannot be certain that we will have access on acceptable terms to the extensive additional financing, qualified personnel and relevant technologies that would be required in order for us to scale-up production and develop effective commercial manufacturing processes and technologies, or that we will be able to enter into collaborative or contractual arrangements on acceptable terms with parties that will meet our requirements in respect of quality, quantity and time lines.
     In addition, we may be dependent upon suppliers of parts for our projectile launching systems and teaming partners with whose weapons platforms our systems may be integrated. Any failure in delivery or performance by these third parties could cause a delay in the development or commercialization of our systems.
Our share price has been and will likely continue to be volatile.
          As Metal Storm is a listed company, our share price will be subject to the numerous influences that may affect both the broad trend in the share market and the share prices of individual companies and sectors. Investors should recognize that the price of shares and options in Metal Storm may fall as well as rise. Our share price has been and is likely to continue to be volatile, particularly due to our relatively limited trading volume. Our share price could fluctuate significantly due to a number of factors, including:
    variations in our anticipated or actual operating results;
 
    sales of substantial amounts of our shares;
 
    announcements about us or about our competitors, including new products;
 
    litigation and other developments relating to our patents or other proprietary rights or those of our competitors;
 
    governmental regulation and legislation;
 
    our available cash resources or the need to seek additional funding through public or private equity or debt financings; and

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    changes in securities analysts’ estimates of our performance, or our failure to meet analysts’ expectations.
     Many of these factors are beyond our control.
     Our major shareholder, James Michael O’Dwyer, beneficially owns approximately 37% of Metal Storm’s ordinary shares. In the past, he has indicated an intention to sell approximately one-half of his shareholding to someone who would likely be a long term investor. Any such sale and any significant subsequent resales may cause volatility in our share price.
We are not currently paying dividends and we may not pay dividends in the future.
     Until we make a profit, our directors will not be able to recommend that any dividends be paid to our stockholders. Our directors will not resolve a formal dividend policy for us until we generate profits. Our future profitability will depend on future earnings, as well as our working capital requirements. Our directors’ current intention is to reinvest our income in the continued development and operation of our business. We may continue to generate operating losses on research projects until such time as our technology, or products resulting from research into our technology, are successfully commercialized. There are a number of factors beyond our control and our directors’ control, for example changes in technology, market competition, exchange rate fluctuations and governmental policy, which may also impact on our profitability and ability to pay dividends.
We have been, and likely will be again, classified as a passive foreign investment company for U.S. federal income tax purposes.
     We believe that we were a passive foreign investment company (“PFIC”) for U.S. federal income tax purposes in 2000, 2002, 2003, 2004 and 2005 but not in 2001. We expect that Metal Storm will be a PFIC again in 2006.
     For any U.S. holder that owns our American Depositary Shares or ordinary shares during any taxable year in which we qualify as a PFIC, our status as a PFIC could, among other things, have a material effect on the timing and character of income and gain, for U.S. federal income tax purposes, with respect to the holder’s American Depositary Shares or ordinary shares. It could also have a material adverse effect on the amount of U.S. federal income tax owed by the U.S. holder as a result of owning, receiving dividends on or disposing of American Depositary Shares or ordinary shares.
     See Item 10E “Additional Information — Taxation—U.S. Federal Income Tax Considerations—Passive Foreign Investment Company Status” for a more detailed description of the U.S. tax consequences of owning stock in a PFIC.
     U.S. holders are urged to consult their tax advisors regarding the consequences of owning and disposing of American Depositary Shares or ordinary shares, including the desirability of making, and the availability of, certain elections with respect to our American Depositary Shares or ordinary shares. Metal Storm provides no advice on your taxation matters. The above should not be taken as advice by the reader of this document.

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     Item 4. Information on Metal Storm
A. History and Development of Metal Storm
     Our legal and commercial name is Metal Storm Limited, which was incorporated under the laws of Australia on April 13, 1994. Our principal office is located at Level 34, Central Plaza One, 345 Queen Street, Brisbane, Queensland, Australia, 4000. Our telephone number is 011-61-7-3221-9733. Our website address is www.metalstorm.com. Information on our website and websites linked to it does not constitute part of this annual report. In 2001, our subsidiary Metal Storm Inc. opened an office in Arlington, Virginia, which is close to the Pentagon. Our agent for service of process in the United States is Peter D. Faulkner, 4350 N. Fairfax Drive, Suite 810, Arlington, VA 22203.
     In 1994, we acquired patents and intellectual property from Mr. J.M. O’Dwyer. In consideration for these patents, we issued to Mr. J.M. O’Dwyer 1,125,000 ordinary shares. Between May 1994 and March 1999, a total of 2,625,000 ordinary shares were issued to a variety of investors raising a total of A$1,993,875.
     In anticipation of our initial public offering in Australia, we effected a 21.4 to 1 stock split in March 1999 that increased our issued capital from 3,750,002 to 80,250,042 ordinary shares. In June 1999, we raised A$12 million in an initial public offering in Australia by offering and selling 4,000,000 ordinary shares at an issue price of A$3.00 per share. Our ordinary shares were listed on the Australian Stock Exchange in July 1999 under the symbol “MST.” In May 2000, we effected a 5 to 1 stock split, thereby increasing our issued capital from 84,250,042 to 421,250,210 ordinary shares. From 2001 through 2004, we raised A$27.3 million through a share purchase plan that was available only to Australian residents and various private placements of ordinary shares in Australia. In May 2006, we raised A$2.7 million, net of transaction costs, through a share purchase plan available only to shareholders resident in Australia and New Zealand.
     In 2000, we commenced a Level 1 American Depositary Receipts (“ADR”) program with The Bank of New York as depositary and our ADRs traded on the over-the-counter market. In December 2001, we commenced a Level 2 ADR program with The Bank of New York as depositary and our ADRs commenced trading on the Nasdaq SmallCap Market under the ticker symbol “MTSX”.
     In December 2003, we acquired Seattle-based ProCam Machine LLC in exchange for the issuance of 5,524,926 ordinary shares of Metal Storm Limited and US$189,739 (A$256,716) cash. As part of this acquisition, Metal Storm assumed US$2.2 million (A$2.9 million) in debt. ProCam is a manufacturer of precision-machined parts for the defense, electronics, aircraft and space propulsion industries. In June 2005, Metal Storm sold the ProCam business. The sale enabled Metal Storm to preserve cash resources and better focus on commercializing its 40mm weapons systems.
     Other than the ProCam Machine LLC transactions outlined above, we have not made any material capital expenditures or divestitures since January 2003. We have no material capital expenditures or divestitures currently in progress.
B. Business Overview
     Metal Storm is a technology company with offices in Australia and the United States of America. We specialize in the research, design, development and integration of projectile launching systems utilizing our “electronically initiated / stacked projectile” technology for use in the defense, homeland security, law enforcement and industrial markets.
Strategy
     The focus of our engineering and development activities is on our 40mm weapons system and each of its key components — specifically the launcher, munitions, ignition systems, fire control processors and re-loading systems. The 40mm weapons system category has been chosen as our primary focus in the short to medium term because we believe it provides the quickest path to the initial commercialization of our technology. We believe that Metal Storm technology is ideally suited to the 40mm category because the market for 40mm weapons and munitions is worldwide and covers both military and law enforcement sectors and this market is growing due to the increased use of 40mm weapons in modern warfighting.
     The majority of our current and ongoing work is focused on low velocity/low pressure systems with progression into some specific higher velocity applications planned to occur in the near future. Metal Storm’s current commercialization strategy has the following key elements:
  §   Completing the engineering of current Metal Storm 40mm weapon system components to a standard suitable for certification by relevant government agencies;
 
  §   Building and demonstrating new and selected existing weapon prototypes designed to attract demand for early adoption by end-users;
 
  §   Producing weapon prototypes to customer specifications in funded programs;
 
  §   Obtaining certification of components and product prototypes by relevant government agencies, particularly the U.S. Department of Defense;

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  §   Merging our technology into fully integrated weapons systems that are adaptable to a variety of applications in current demand by military customers;
 
  §   Securing customer production orders for certified products; and
 
  §   Using the successful commercialization of 40mm weapons systems as a platform from which we can then branch out into other weapons categories and other applications of our core technology.
     Contracted research and development projects provide a valuable source of market opportunities as well as generating revenue. Contracts are generally funded by potential customers and are a recognized channel to market, particularly in the U.S. defense industry, where they can lead to eventual purchase orders. Most contracts are for 40mm weapons systems or components so the development work required aligns to the strategy points discussed above. Those contracts not for 40mm weapons systems allow us the opportunity to further refine the technology while providing additional revenue.
     Over the past 18 months, we have been focused on progressing the development, engineering and testing of the Metal Storm 40mm weapon system components to improve designs and materials with the aim of developing a systems package capable of “plug and play” integration with other systems, including ancillary mounts, optical targeting systems and unmanned platforms. To this end, we have created a range of proof-of-concept 40mm weapons systems that exploit the unique capabilities of our electronically initiated / stacked projectile technology and which match identified market needs and built and demonstrated several Metal Storm 40mm weapons system proof-of-concept models to customer specifications in collaboration with development partners. We have also prepared and submitted proposals for funded contracts based on the Metal Storm 40mm weapons system and formalized relationships with key industry partners such as ST Kinetics, Electro Optic Systems and the U.S. Army’s Armament Research, Development and Engineering Center (“ARDEC”). We have undertaken the collaborative development and testing of munitions for the Metal Storm 40mm weapons system with ST Kinetics and ARDEC, with the aim of ultimately taking off-the-shelf warheads that have been certified for military use and converting them to Metal Storm configuration. We expect that these collaborative efforts will reduce the time which would otherwise be required for certification of those munitions.
     To help us achieve these goals, we have populated Metal Storm with highly qualified professional staff with specific skills and experience in required areas, built a strong team of engineers and scientists to focus on the accelerated development of potential products and increased our business development activities in key U.S. defense and homeland security markets and selected international markets.
Recent achievements
     Recent achievements, arising out of this strategic focus, include the successful completion of live firing trials and demonstrations of the 40mm weapons technology in several different configurations, including:
  §   Live firing trials and demonstrations held at the U.S. Army’s Picatinny Arsenal range facility of a purpose-built Metal Storm 40mm weapon system integrated with a Talon unmanned ground vehicle, special mount and optical targeting systems in March 2005;
 
  §   Demonstration by Australian Defense Science and Technology Organization (“DSTO”) of the Area Denial Weapon System concept prototype using Metal Storm 40mm weapon technology in July 2005;
 
  §   Demonstration by DSTO of the Advanced Individual Combat Weapon concept prototype using Metal Storm 40mm weapon technology in August 2005;
 
  §   The test firing of Metal Storm 40mm grenade launchers from the Dragonfly Unmanned Aerial Vehicle in a tethered position to test the stability of mounts and test remote control systems.;
 
  §   The successful test firing of high explosive, enhanced blast explosive and high explosive air burst munitions in conjunction with ST Kinetics in February 2006;
 
  §   The successful test firing of the Redback TM Weapon System and munitions in collaboration with Electro Optic Systems and ST Kinetics in February 2006; and
 
  §   The initial test firing and trials of a prototype high explosive 40mm grenade assembly developed in collaboration with ARDEC in March 2006.
Engineering
     Metal Storm is engaged in a focused period of engineering work that will include testing and prototyping the various elements of our 40mm weapons system. Testing of four prototype 40mm high explosive rounds has been completed. This includes a standard high explosive munitions, high explosive air burst and thermobaric (enhanced blast) rounds. High explosive dual purpose munitions adaptations are continuing and are expected to be completed and moved into the certification process by late 2006. Our current engineering focus is to move these munitions into operationally ready Metal Storm-based 40mm low velocity systems while continuing to progress on the next generation

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Metal Storm 40mm high velocity systems. Current schedules include the final development of the RedbackTM (light-weight remotely operated weapons system) and the 3-GL man-fired 40mm grenade launcher. Initial testing of both systems has begun, with RedbackTM scheduled to begin systems demonstration in early 2007 for various Australian, U.S. and international customers. Further development of the 3-GL is currently underway and business negotiations for its production and distribution are just beginning, with the goal of moving it to fielded product mid-2007.
     Most of the above work is being carried out in our Australian office, while our U.S. office is focused on contract performance on customer-specified systems. The combined tactics of systems development and application insertion are designed to help assure customer interest in Metal Storm-enabled systems, while providing feedback to Metal Storm engineers. The current labor breakdown is that approximately 90% of the Australian engineering effort is focused on RedbackTM and 3-GL with 10% focused on high-velocity systems. In the United States, approximately 90% of the engineering effort is concentrated on contracted systems development and 10% is on internal R&D for systems improvements.
     Business Development
     Our strategy is to focus on winning commercial contracts for the supply and integration of complete weapon systems that employ Metal Storm’s technology. Our business model is to integrate our unique technology into a range of military systems as the foundation for growing a wider business. We aim to generate a range of products that exploit the unique selling points of our technology and which match current market needs in areas where sustainable long-term profit growth is possible. Our business development effort is focused on building a customer base for a line of products based on our 40mm weapons system technology.
     A key element of our business development strategy is the use of live-fire demonstrations to showcase the technical and operational capabilities of our technology and prototype products. These demonstrations serve a technical development and data gathering purpose, and a business development purpose. Typically we would aim to conduct these demonstrations for a select audience of military and defense industry decision-makers.
     Metal Storm also seeks business partners who are experts in key areas such as target acquisition and aiming, turreting and recoil management systems, and communications protocols. In the area of targeting, we are interested in all available technologies, including optical, laser, radar and infrared functionalities. We are also seeking partners among software and communications companies that can help Metal Storm further develop the essential command, control, communications and computer capabilities needed for remotely controlled systems. As business development efforts continue, we expect to receive contracts to produce prototypes and otherwise take our products through the development and testing phases.
Technology
     Metal Storm’s technology is an electronically initiated, stacked projectile system that removes the mechanisms required to fire a conventional weapon. Effectively, the only parts that move in Metal Storm’s technology are the projectiles contained within the barrels. Multiple projectiles are stacked in a barrel. The technology allows each projectile to be fired sequentially from the barrel.
     Metal Storm’s fully loaded barrel tubes are essentially serviceable weapons, without the traditional ammunition feed or ejection system, breech opening or any other moving parts. Metal Storm barrels can be effectively grouped in multiple configurations to meet a diversity of applications.
     Metal Storm’s technology is ideally suited to the new generation of ‘network centric’ weapons that are designed to connect with today’s battlefield. Importantly, Metal Storm enabled systems are designed to be capable of local or remote operation through a computerized fire control system. This is of particular value as combat becomes focused on remotely operated weapons and the use of robotic platforms.
     Our technology achieves its performance through the concept of numerous projectiles stacked in a barrel, in which each projectile, in most configurations, has its own propellant load, such that the leading propellant can be reliably ignited to fire the projectile, without the resulting high pressure and temperature causing unplanned blow-by ignition of the following propellant load, and without collapse of the projectile column in the barrel.
     Our technology has the following features and benefits:
    electronically programmable rates of fire from single shots to ultra-rapid rates;
 
    no moving parts, resulting in increased reliability and availability because there is less maintenance required and decreased possibility of malfunction;
 
    increased firepower to weight ratio resulting in a lighter weapon with greater firepower compared to conventional weapons;
 
    modular pods that could operate as a complete weapon system in one container;
 
    100% electronic operation;

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    the potential of grouping multiple calibers and multiple lethalities in one gun allowing the user to vary the use to a specific situation;
 
    numerous hybrid configurations and Special Forces applications that could result in enhanced capabilities for use behind enemy lines; and
 
    fast second round strike capability before recoil effect.
Internal Product Development
     Currently, the two primary internally-funded development programs consist of RedbackTM, which is a 4 barrel pod for a rapid slewing weapons mount, and 3GL, which is a rifle-mounted or handheld 3-shot grenade launcher. This research not only encompasses the weapons themselves, but also associated electronic fire control systems and projectile technology. Other projects include the development of a 40mm fireworks launcher capable of accurately placing projectiles in a given space and pattern and the development of weapon and recoil systems for unmanned vehicles.
          RedbackTM
     The RedbackTM weapons system is a multi-barreled pod that is designed to detect a target, slew into position, and be fired at extremely high speeds. The system includes detection, acquisition and tracking electronics that are ultimately aimed at protecting vehicles from incoming rocket-propelled grenade, or RPG, attacks. Unlike other anti-RPG systems, RedbackTM could be used as a conventional weapon for engaging conventional targets.
     RedbackTM is being developed in a consortium with Electro Optic Systems Holdings Limited (“EOS”), who will supply the gimbal, mount and acquisition and tracking electronics, and Singapore Technologies Kinetics, who will provide the ammunition. The weapon components are being funded and developed by Metal Storm. The RedbackTM program commenced in November 2005 and is currently focused on producing a number of systems for testing and evaluation by the U.S. Department of Defense and others in the second half of 2006. The first fieldable systems are scheduled to be available in late 2007. The project has already demonstrated the adaptation of existing ST Kinetics high explosive rounds to Metal Storm configuration for stacking ammunition in a barrel. Trials were conducted in Singapore in February 2006.
     Effective August 2, 2005, Metal Storm entered into an exclusive Teaming Agreement with EOS for the joint development, manufacturing and marketing of a stabilized remote weapon system. The agreement terminates on December 31, 2012 unless terminated earlier by joint agreement of the parties or upon the occurrence of certain termination events. Each party is responsible for its own development costs under the agreement. The agreement provides that intellectual property which is developed solely by one party under the agreement will be owned solely by that party. Intellectual property that is developed through the collaboration of both parties will be owned by EOS except for technology that can only be utilized in connection with Metal Storm’s stacked-round systems, which will be owned by Metal Storm. If a weapon system developed under the agreement is ordered by a customer, Metal Storm will be paid for the components it provides under the terms of a separate purchase agreement.
          3GL
     The 3GL is a grenade launcher that is being designed to attach to an existing assault rifle and be capable of being mounted to a separate stock for stand-alone use. The advantage of the system is that it would be able to fire three grenade rounds without reloading, enabling the soldier to maintain aim at the target. It is expected that, once developed, the 3GL would provide a higher probability of hitting a target than a conventional grenade launcher. This project is being developed entirely by Metal Storm with munitions potentially being supplied by ST Kinetics. Several 3GL proof-of-concept models have been built and successfully tested in Australia.
          Fireworks
     Metal Storm holds a number of patents relating to the formation of aerial images. The fireworks research is intended to add value to this intellectual property. Initial development has demonstrated the ability to launch, spin stabilize and light the fuse of fireworks projectiles in a stacked configuration.
          Systems for Unmanned Vehicles
     As they are lightweight with all projectiles pre-stacked in the barrel, Metal Storm weapon systems are well suited to robotic vehicle applications. Additionally, with the lack of mechanical parts associated with conventional reload systems, the weapons are expected to be extremely reliable and well suited to tele-robotic applications.

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     Metal Storm has already demonstrated such systems, including a series of live fire demonstrations that were held at the U.S. Army’s range facility at Picatinny Arsenal in New Jersey in March 2005. The demonstrations consisted of multiple live firings of a purpose-built version of the Metal Storm 40mm weapon system, mounted on a TALON unmanned ground vehicle produced by Foster Miller.
     We have also worked with Dragonfly Pictures Inc., a U.S. designer/manufacturer of unmanned helicopters, to weaponize a version of its DP-4X Vertical Take Off and Landing Unmanned Aerial Vehicle. In the third quarter of 2005, test firings of our weapon system from a DP-4X were conducted. The tests included a firing of inert 40mm grenade rounds in rapid sequence while mounted on a tethered DP-4X. The firings demonstrated the integration of our generic 40mm ballistics system with the remotely operated DP-4X. The Dragonfly weaponization program is currently inactive for reasons beyond Metal Storm’s control. Metal Storm is considering other unmanned aerial vehicle platforms from which it could conduct weaponization demonstrations.
          Handgun
     We have been developing a production prototype “smartgun” version of the Metal Storm electronically initiated handgun, which is based on our small caliber launching system in conjunction with the New Jersey Institute of Technology (“NJIT”). Using the NJIT’s Dynamic Grip Recognition authorizing technology, this product would be designed to meet the requirements specified under legislation in the State of New Jersey that become effective in 2007, and then other markets.
     There is currently a variety of gun locking systems designed to restrict access to unauthorized users that can be added to existing handguns. Manufacturers have, however, experienced difficulty in developing conventional mechanical handguns that operate effectively and practically when the electronic or other authorizing systems are added. By contrast, because the Metal Storm handgun is 100% electronic, it would avoid the problems associated with most add-on electronic systems. The electronically initiated handgun is designed with an ease of integration to a variety of electronically controlled user and authorizing devices.
     After thorough analyses of the state of our handgun technology, the challenges of obtaining certification, likely production and marketing costs, the state of competition and market sensitivities, and the time and funds required to successfully generate a product, it is clear that the handgun, in either its basic or Smartgun form, should not be a primary focus for internal investment at this point. We will, however, continue to collaborate with and explore alternative strategies with external parties for the commercial development of the handgun and we will continue to add to our technical base in this area through work done on small caliber military systems.
          Low Velocity and Less Than Lethal munitions development — U.S. Army ARDEC
     Effective August 15, 2005, Metal Storm entered into a Cooperative Research and Development Agreement (“CRADA”) with the U.S. Army’s Research, Development and Engineering Center (“ARDEC”) to collaborate in demonstrating, evaluating and adapting Metal Storm’s stacked-round technology to weapons systems of interest to the U.S. military. Work is continuing as planned on the development and testing of existing U.S. Department of Defense 40mm munitions adapted to Metal Storm configuration. This work is intended to lead to the availability of a variety of lethal and less than lethal U.S. Department of Defense munitions for use in stacked round Metal Storm weapon systems. Under the CRADA, Metal Storm fired a prototype high explosive 40mm grenade assembly in March 2006. This firing will provide the foundation for developing a number of Metal Storm stacked munitions utilizing existing certified warheads and components.
     Research and development into the application of the technology to small and medium direct fire, area defense, air defense and less-than-lethal systems is ongoing under the CRADA. The agreement’s term is five years, unless terminated earlier mutually by both parties or unilaterally upon 30 days written notice of one party to the other. Metal Storm has indemnified the U.S. government for all liabilities arising out of the use of ARDEC’s research developments or products made with the use of ARDEC’s technical developments by Metal Storm or third parties acting on Metal Storm’s behalf.
     Specific projects under the CRADA are to be undertaken pursuant to a Statement of Work, which is negotiated and executed at the start of each new project. Statements of Work contain provisions governing project scope, ownership of co-developed technology and intellectual property and cost responsibility. The current Statement of Work provides that Metal Storm is responsible for funding both its and ARDEC’s expenses under the project, with total costs estimated at approximately US$548,167 (A$746,618). The agreement is terminable as discussed above by either Metal Storm or ARDEC with no penalty or further payments required. The anticipated payments remaining under the Statement of Work total approximately US$379,452 (A$516,824).
          Low Velocity 40mm launcher — Systems Upgrade
     This program involves the design, development, integration, test, evaluation and proof-of-concept model production of the next generation design of Metal Storm 40mm low velocity launcher and fire control system. The current generic version of the Metal Storm 40mm grenade launcher has been used in numerous testing exercises in the course of Metal Storm’s research and development activities. This program is intended to mature and upgrade the 40mm grenade launcher design and to introduce additional requirements dictated by the projected

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end-user environment, the logistics requirements of increased reliability and supportability, and the minimization of production costs.
     The upgraded generic version of the low velocity 40mm grenade launcher has the potential to be used in multi-barrel arrays retro-fitted alongside conventional 40mm weapons. This would provide a hybrid weapon system with multiple munition types utilizing the existing mount, targeting and aiming system of the conventional weapon. Metal Storm believes that this add-on would be relatively easy to install and would offer the user a considerable increase in the firepower and versatility of their existing weapon stations at comparatively low cost. The desired outcomes will be to produce a limited number of working proof-of-concept models to pre-certification stage for demonstration and testing by potential end-users, and to secure contracts for the supply of certified weapons and munitions.
          Electronically Initiated Munitions Development — ST Kinetics
     This program involves the development of a range of electronically initiated munitions in collaboration with Singapore Technologies Kinetics Ltd (“ST Kinetics”), specifically for use with Metal Storm weapons. The range will be based on the existing ST Kinetics family of 40mm munition types, adapted to Metal Storm configuration. The program commenced in September 2005. High explosive and enhanced blast rounds plus air burst munitions were successfully test-fired at ST Kinetics’ Bukit Timah range facility in Singapore in February 2006. Production design munitions are expected to be available for certification testing by the fourth quarter of 2006.
     Effective September 28, 2005, Metal Storm entered into an exclusive Teaming Agreement with ST Kinetics for the development, testing, manufacture and marketing of munitions to be used in conjunction with the weapons systems being developed under the teaming agreement with EOS and other under Metal Storm projects. The agreement terminates on December 31, 2012 unless terminated earlier by joint agreement of the parties or upon a default by one party. The agreement provides that intellectual property which is developed solely by one party under the agreement will be owned solely by that party. Intellectual property that is developed through the collaboration of both parties will be owned sole or jointly by Metal Storm except for technology relating to the internal workings of the warheads, which will be owned by ST Kinetics. Each party is responsible for its own development costs under the agreement. If munitions developed under the agreement are ordered by a customer, the parties will negotiate the terms of payment and manufacture under a separate purchase agreement.
External Development Programs
     In addition to our internal product development programs, we seek external funding from military and government agencies to develop products in collaboration with other parties.
     U.S. Department of Energy Contract — Short Range Protection System
     Metal Storm has a contract with the U.S. Department of Energy that provides for the development of a Short Range Protection system based on Metal Storm 40mm weapons technology. This is our first contract that has direct application in the U.S. homeland security market. The contract, which commenced in October 2005, is expected to be completed by August 2006.
     U.S. Navy SBIR Contract — Metal Storm Active Protection System
     This contract is for the development of a remotely controlled Active Protection System for mounting on various types of unmanned ground vehicles. It is funded through a Phase II Small Business Innovation Research (“SBIR”) contract sponsored by the U.S. Navy’s Space and Naval Warfare Systems Command and the Office of Naval Research. Metal Storm is providing an unattended remotely operated weapon system designed to operate in a networked environment for the protection of very high value assets. The contract, which commenced in January 2006, is scheduled for completion by July 2008.
     U.S. Army SBIR Contract — Metal Storm Crowd Control System
     This contract is for the development and testing of a Crowd Control System using Metal Storm 40mm weapons technology and less than lethal munitions. It is funded through a U.S. Army Phase II SBIR contract sponsored by the U.S. Army ARDEC. Metal Storm is developing and fabricating specific less than lethal rounds capable of being fired from Metal Storm weapon systems in a variety of configurations as a means to stop a crowd from advancing. This contract, which commenced in December 2005, is scheduled for completion in January 2008.

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     StarChase Contract — Pursuit Management System Phase II Lead System Integrator
     U.S. company StarChase LLC has engaged Metal Storm to act as the lead systems integrator on the commercialization of the patented StarChase vehicle tagging technology. The contract requires Metal Storm to generate a production-ready configuration of the StarChase system, and to produce, implement and provide support for a limited number of systems to be used for operational testing. The contract commenced in May 2006 and is scheduled for completion by December 2006.
     U.S. Marine Corps — 18mm Stacked Round Firing System
     This contract is for the design, fabrication and test of 18mm stacked round firing systems. Under the terms of the contract, Metal Storm will explore the feasibility of employing 18mm fin stabilized high explosive projectiles from an accessory under-barrel weapon for the M-16A4 service rifle. The firing technology will be a test bed potentially leading to Marine Corps experimentation with larger diameter finned projectiles than are possible with shot gun-launched munitions. The contract was announced on July 13, 2006 and is scheduled for completion by April 2007.
Research Agreements with Government Agencies
     DSTO Research Agreement
     In April 2001, we entered into a five-year research agreement, which was amended in September 2002, with the Commonwealth of Australia as represented by the Defense Science & Technology Organization. Pursuant to this agreement, we have granted DSTO a non-exclusive, worldwide, perpetual license to use our scientific and technical know-how and information in relation to their gun hardware and gun system technology for defense use and international collaboration.
     This agreement also specifies our intellectual property ownership rights, and sets out the terms and conditions under which we may commercialize the technology developed under it. In particular, this agreement provides that any improvements to our gun hardware or gun system technology, including the intellectual property, developed or acquired by or for DSTO from DSTO’s further research, will be owned by us. However, we must pay royalties to DSTO at agreed rates if they commercialize such improvements.
     DSTO Technology License Agreement
     In April 2001, we entered into an agreement with the Commonwealth of Australia to license from DSTO certain technology that DSTO has used as a design, evaluation or modeling tool in appraising our gun system technology. We also have the right to improvements in the DSTO technology developed during the term of the license agreement.
     This agreement is for five years or such further period as we agree with DSTO, but will in any event terminate at the same time as the DSTO research agreement. This agreement provides that if we commercialize any of the DSTO technology described above, we must pay DSTO a royalty calculated on our gross revenues on manufacture, sales or licensing, after taking into account the proportion of the value of DSTO’s intellectual property incorporated into the products based on our technology.
Competition
     Until we commercialize a product using our technology, we continue to compete for technology research and development funding available through various areas that are administered by the U.S. Department of Defense and other government agencies, including, for example, under the SBIR Program.
     The commercial success of products that we develop will depend in part on competing products. Large, well-established defense companies and other entities with collaborative arrangements with the government are also engaged in research and development and may have considerably greater resources than us to develop applications for defense technology. We cannot be certain that our competitors will not succeed in developing technologies and products that are more effective than any which we are developing, or which would render our technology and products obsolete or non-competitive.
     We also compete with manufacturers of handguns in developing the technology for our handgun. These companies are in the process of developing or have developed technology similar to ours that may have some of the same or similar features to our handgun.
Regulation
     Our research and development activities are, and the production and marketing of the products that we are developing are likely to be, subject to regulation by governmental authorities in Australia, the United States and other countries where we may market our technology. Prior to marketing, our technology and any product may be required to undergo rigorous testing as well as extensive regulatory approval processes.

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     Australia
     We have authority under the Weapons Act 1990 (Queensland) to engage in scientific or experimental work. In compliance with the Australian Weapons Act and Australian Controls on the Export of Defense and Strategic Goods, we have a weapons movement procedure policy. We do not currently envisage manufacturing any products in Australia, however, in the event that we do, we would be required to obtain a manufacturer’s license to enable us to manufacture and export our products. In addition, we would be regulated by the Australian Department of Defense Export Controls under which we would be required to obtain an export distribution license. Licenses and permits may be difficult to obtain and retain depending on government policies, customs, changes in political leadership, and other factors. These processes and obtaining licensing and permits may take many years and require the expenditure of substantial resources.
     To the extent our activities under Australian government contracts may require access to or result in the development of information classified by the Australian government, such activities may become subject to Australian government regulations.
     Products to be manufactured using our technology may also be subject to government regulation. These may include regulations governing use, specification, manufacture, handling, disposal, packaging, labeling, transport and import and export in Australia and in each of the countries into which such products are intended to be exported.
     United States
     Sales to U.S. military and to federal law enforcement agencies will be regulated by the U.S. Federal Acquisition Regulations and Defense Federal Acquisition Regulations. Sales to local and state law enforcement agencies will be subject to the procurement regulations of the jurisdictions involved, as well as applicable Federal regulations. We plan to be in compliance with all regulatory and licensing requirements.
     To the extent our activities under U.S. government contracts may require access to or result in the development of information classified by the U.S. government, such activities may become subject to U.S. government regulations, including the Defense Industrial Security Regulations and the National Industrial Security Program Operating Manual, which impose restrictions on a foreign company’s ability to control or to have access to information in the possession of a cleared U.S. company performing classified contracts. The U.S. and Australian governments have entered into a Statement of Principles for Enhanced Cooperation in Matters of Defense Equipment and Industry that is intended to facilitate sharing classified information between the governments and cleared companies.
Intellectual Property
     We principally rely upon patents, trade secret, copyright and contract law to protect the intellectual property in our proprietary technology. See Item 3D “Key Information – Risk Factors” for a discussion of risks associated with protecting our intellectual property.
     We aggressively pursue patent applications for new inventions. Since our inception, we have filed many patent applications, including, but not limited to, applications relating to:
    stacked projectile delivery systems and stacked projectile weapon systems, in particular the sealing, reload and ignition thereof;
 
    technology related to encoding weapons to permit authorized access only;
 
    ammunition and projectiles;
 
    electronic firing technology;
 
    area denial;
 
    fire fighting;
 
    increased first shot kill probability;
 
    fireworks;
 
    missile defense and target interception;
 
    directional control of missiles;
 
    unmanned aerial vehicle weaponization;
 
    adapting conventional munitions to Metal Storm configuration; and

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    selectable kinetic energy weapons
     As of December 31, 2005, we had
    17 granted U.S. patents and 20 pending U.S. patent applications;
 
    20 granted Australian patents and 15 pending Australian patent applications; and
 
    100 other patents granted outside the United States and Australia and 235 pending applications outside the United States and Australia.
Raw Materials
     We use the following principal raw materials: aluminum, steel, steel alloys, graphite fiber, epoxy resins, adhesives, nitrates, propellants and general electronic materials. Such materials are easily obtained from a variety of sources and are generally readily available in the market. With the exception of aluminum and steel, the prices of such materials have not been subject to large fluctuations.
Seasonality
     Our business is primarily research and development and is not subject to seasonality fluctuations. However, U.S. Department of Defense contracts are typically awarded on a cyclical basis, and many of our research and development programs will follow this cycle.
C. Organizational Structure
     Not applicable.
D. Property, Plant and Equipment
     We lease approximately 3,347 square feet of office space in Brisbane, Australia. The annual gross rental payments are approximately A$117,030 payable in monthly installments of approximately A$9,753. The lease expires on December 31, 2006.
     We lease approximately 6,149 square feet of office space in Arlington, Virginia. The annual gross rent effective from April 2006 to April 2007 is US$202,176 (A$276,915), payable in monthly installments of approximately US$16,848 (A$23,076). The lease contains an escalation clause of 2.7% per annum for the life of the lease. The lease expires on April 30, 2010.
     In connection with the ProCam business, we leased approximately 21,400 square feet of warehouse space and approximately 3,600 square feet of office space in Mill Creek, Washington. The annual gross rental payments are US$226,640 (A$308,690), plus an annual adjustment for inflation, payable in monthly installments of approximately US$18,886 (A$25,723). The lease was entered into by ProCam and expires on June 30, 2007. On June 1, 2005, we sold the ProCam business to Monroe Machine Products, Inc. and are no longer utilizing this space We are currently in negotiations to exit the lease. See Note 21 to the accompanying consolidated financial statements for further details about this lease.
Item 4A. Unresolved Staff Comments
     Not applicable.

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Item 5. Operating and Financial Review and Prospects
     You should read the following discussion and analysis in conjunction with Item 3A “Key Information – Selected Financial Data” and our financial statements, the notes to the financial statements and other financial information appearing elsewhere in this annual report. The consolidated financial statements have been prepared in accordance with Australian equivalents to International Financial Reporting Standards (“A-IFRS”), which differs in certain significant respects to U.S. Generally Accepted Accounting Principals (“U.S. GAAP”). Refer to Notes 30 and 31 to the accompanying consolidated financial statements for a description of the significant differences between A-IFRS and U.S. GAAP and a reconciliation of shareholders’ equity and net loss to U.S. GAAP. In addition to historical information, the following discussion and other parts of this annual report contain forward-looking statements that reflect our plans, estimates, intentions, expectations and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. See the “Key Information – Risk Factors” section of Item 3D and other forward-looking statements in this annual report for a discussion of some, but not all factors that could cause or contribute to such differences.
A. Operating Results
Overview
     We are a defense technology company that develops projectile launching systems utilizing electronically fired, stacked projectile technology.
     Since incorporation in 1994, we have incurred A$52,447,234 in operating losses. Our losses have resulted principally from costs incurred in research and development and from general and administrative costs associated with our operations.
     In order to meet Metal Storm’s objectives to develop, manufacture and market commercial products effectively, we will require additional funding until such time that product sales are of sufficient volume to generate positive cash flows from operations. This has taken longer and has cost more than originally anticipated. Based on the expected levels of operating expenditures, in order to continue its operations, Metal Storm will require additional sources of capital. While Metal Storm has previously been successful in raising additional capital, there can be no assurance that we will be able to raise sufficient capital to continue our operations. If we are unsuccessful in our efforts to obtain sufficient financing to continue to fund our current operations, we will be required to significantly reduce or cease operations altogether. Accordingly, there exists a substantial doubt about Metal Storm’s ability to continue as a going concern.
     Our directors believe that Metal Storm will succeed in securing additional funding in the near future. In June 2006, Metal Storm signed an agreement with Harmony Investment Fund Limited to establish a A$5 million short-term working capital loan facility. Metal Storm has also signed a preliminary agreement with Harmony Capital Partners to facilitate and sub-underwrite a Renounceable Rights Offer of A$27.5 million in unsecured Convertible Notes with attaching Options that is being offered to shareholders resident in Australia and New Zealand. The Renounceable Rights Offer is anticipated to commence in late July 2006 and close in August 2006 and is subject to certain conditions. There can be no assurance, however, that this financing transaction will occur or that the final terms will be substantially the same as the terms of the preliminary agreement.
     If such funding is unavailable, there is significant uncertainty as to whether Metal Storm will continue as a going concern and, therefore we may realize the value of our assets and settle our liabilities at amounts different from those stated in our financial statements. As announced at Metal Storm’s Annual General Meeting on April 28, 2006, an aggressive cost cutting program has been introduced that Metal Storm expects to produce significant cost savings. Further cost saving strategies will be introduced if additional funding is not available.
     No adjustments have been made to the financial statements relating to the recoverability and classification of the asset carrying amounts or classification of liabilities that might be necessary should Metal Storm not continue as a going concern.
     We intend to continue to devote substantial resources to research and development as we transition our technology from proof of concept to product implementation. Most of our funding for our external development programs has come from equity capital raisings in Australia. We have also received revenue from grants and contracts under various government programs. We fund our internal product development through our accumulated funds.
     We expect to continue to incur losses as we expand our product development and commercialization programs. We expect that losses will fluctuate from period to period and that such fluctuations may be substantial as a result of, among other things, the results of our research and development programs, the number of future prototypes we produce and test and potential design changes required as a result of testing. We are approaching the latter stage of product development and do not expect any revenues from product sales until at least the second half of 2007. While there has been significant interest in our proof-of-concept demonstrations, we cannot give assurance that we will manufacture or sell our products successfully or ever achieve or sustain profitability.
     In December 2003, we acquired ProCam Machine LLC, which manufactures precision-machined parts for the defense, electronics, aircraft and space propulsion industries. On June 1, 2005, we sold the ProCam business to Monroe Machine Products, Inc. The results of operations of ProCam have been recorded on our income statement as “loss after tax from discontinued operations”.

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Where We Derive Our Revenue
     In 2005 and 2004, our principal sources of revenue were contract funding and interest income.
Critical Accounting Policies
     Our discussion and analysis of our operating and financial review and prospects are based upon our financial statements, which have been prepared in accordance with A-IFRS. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of revenue, assets, liabilities and expenses. We re-evaluate our estimates on an on-going basis. Our estimates are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.
     We believe the following are our critical accounting policies that affect our more significant judgments and estimates used in the preparation of our financial statements.
Revenue Recognition for Rendering of Services
     We earn revenue from rendering systems integration work and other services under contracts. Revenue is recognized when key milestones or deliverables specified within each agreement are achieved and accepted by all parties to the agreement, no performance obligation with respect to the milestone or deliverable remains, the arrangement fee is fixed, and collectibility is reasonably assured. There is some judgment involved by management in determining the achievement of milestones and the percentage of work completed under contracts.
     See Note 3 to the accompanying consolidated financial statements for a discussion of our overall policy on revenue recognition.
Share-based Payment Transactions
     We provide benefits to our employees (including directors) in the form of share-based payment transactions, whereby employees render services in exchange for shares or rights over shares (‘equity-settled transactions’).
     We currently provide these benefits through:
(i) options issued to executives and employees as part of a remuneration package issued in accordance with the power contained in Metal Storm’s constitution, and
(ii) the Employee Share Option Plan (ESOP).
     The cost of these equity-settled transactions with employees is measured by reference to the fair value at the date at which they are granted. The fair value is determined using an appropriate option valuation model.
     In valuing equity-settled transactions, no account is taken of any performance conditions, other than conditions linked to the price of the shares of Metal Storm Limited (‘market conditions’).
     The cost of equity-settled transactions is recognized, together with a corresponding increase in equity, over the period in which the performance conditions are fulfilled, ending on the date on which the relevant employees become fully entitled to the award (‘vesting date’).
     The cumulative expense recognized for equity-settled transactions at each reporting date until vesting date reflects (i) the extent to which the vesting period has expired and (ii) the number of awards that, in the opinion of the directors of Metal Storm, will ultimately vest. This opinion is formed based on the best available information at balance date. No adjustment is made for the likelihood of market performance conditions being met as the effect of these conditions is included in the determination of fair value at grant date.
     No expense is recognized for awards that do not ultimately vest, except for awards where vesting is conditional upon a market condition.
     Where the terms of an equity-settled award are modified, as a minimum an expense is recognized as if the terms had not been modified. In addition, an expense is recognized for any increase in the value of the transaction as a result of the modification, as measured at the date of modification.
     Where an equity-settled award is cancelled, it is treated as if it had vested on the date of cancellation, and any expense not yet recognized for the award is recognized immediately. However, if a new award is substituted for the cancelled award, and designated as a replacement award on the date that it is granted, the cancelled and new award are treated as if they were a modification of the original award, as described in the previous paragraph.
     The dilutive effect, if any, of outstanding options is reflected as additional share dilution in the computation of earnings per share.

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     We have applied the requirements of AASB 1 First-time Adoption of Australian Equivalents to International Financial Reporting Standards in respect of equity-settled awards and have applied AASB 2 Share-Based Payments only to equity instruments granted after November 7, 2002 that had not vested on or before January 1, 2005.
     Transfers of an entity’s equity instruments by its shareholders to parties that have supplied goods or services to the entity (including employees) are considered share-based payments. These instruments are measured at the fair value of goods or services received. Where the fair value of the goods or services can not be reliably measured we measure the fair value of the equity instruments granted.
     Effective January 1, 2005, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 Revised (“SFAS 123(R)”), “Share-Based Payment”, using the modified-prospective-transition method. Under the transition method, compensation costs recognized during the year ended December 31, 2005 include the unvested portion of all share based payments granted prior to January 1, 2005, and compensation costs for all share-based payments granted subsequent to January 1, 2005 based on the grant date fair value estimated in accordance with the provisions of 123(R). Results for prior periods have not been restated.
     As a result of adopting SFAS 123(R) on January 1, 2005 Metal Storm’s loss before income taxes and net loss for the year ended December 31, 2005 are both A$409,728 higher than if we had continued to account for share-based compensation under Accounting Principles Board Opinion 25 (“APB 25”). Basic and diluted loss per share for the year ended December 31, 2005 was A$(0.0007) higher than if we had continued to account for the share-based compensation under APB 25.
     The difference between the recognition criteria under APB 25 and A-IFRS resulted in a reduction in the share-based payment expense of A$335,624 in 2004 under U.S. GAAP.
     There are no differences in share-based payment expense between U.S. GAAP and A-IFRS in 2005, as a result of the adoption of SFAS
123(R).
Comparison of Annual Results of Operations
     2005 compared with 2004
     Revenue. Revenue decreased A$6,556 (0.8%) from A$837,201 in 2004 to A$830,645 in 2005 due to lower interest revenue, which was A$599,902 in 2005 compared to A$794,565 in 2004. This decrease was partially offset by contract revenue increasing by A$188,107 from A$42,636 in 2004 to A$230,743 in 2005.
     Expenses. Total expenses decreased A$1,967,138 (15.4%) from A$12,758,313 in 2004 to A$10,791,175 in 2005. Significant movements in operating expenses were:
    Employee expenses increased A$717,181 (19.1%) from A$3,751,459 in 2004 to A$4,468,640 in 2005, primarily due to a termination payment of A$500,000 made to Mr. J M O’Dwyer upon his resignation in 2005 plus the costs of additional engineering staff in Australia.
 
    Professional fees decreased A$247,204 (12.2%) from A$2,021,573 in 2004 to A$1,774,369 in 2005 due to cost savings achieved through performing more work in-house rather than using external consultants.
 
    Research and development expenses increased A$181,319 (11.2%) from A$1,613,365 in 2004 to A$1,794,684 in 2005 principally due to higher research and development activity in both the United States and Australia, particularly higher research and development activity related to our core 40mm technology.
 
    Administrative expenses decreased A$397,966 (30.0%) from A$1,326,897 in 2004 to A$928,931 in 2005 primarily due to aggressive cost saving activities.
 
    Facilities and equipment expenses increased A$103,579 (24.7%) from A$419,114 in 2004 to A$522,693 in 2005 primarily due to higher rental costs at our Arlington, Virginia office, which was expanded in late 2004 to support our greater R&D and business development focus.
 
    Travel and entertainment expenses decreased A$362,752 (45.5%) from A$796,611 in 2004 to A$433,859 in 2005 primarily due to an increased focus on cost savings during the year, particularly in lower travel expenses.
 
    Public relations and compliance expenses decreased A$122,924 (19.9%) from A$617,710 in 2004 to A$494,786 in 2005 primarily due to savings achieved through more work performed in-house rather than using external consultants.
 
    In 2004 we had an A$1,834,152 impairment loss on the goodwill arising from the acquisition of ProCam. We had no goodwill impairment in 2005.
Net Loss. As a result of the foregoing, our net loss decreased from approximately A$13.1 million in 2004 to A$10.9 million in 2005. Due to our continuing losses, no income tax expense has been recognized. Refer to Notes 30 and 31 to the accompanying consolidated financial statements for a description of the significant differences between A-IFRS and U.S. GAAP and a reconciliation of shareholders’ equity and net loss to U.S. GAAP.

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Effects of Currency Fluctuations
     Our functional currency is the Australian dollar. We translate our financial statements denominated in foreign currency in accordance with A-IFRS. The reporting currency for all periods presented is the Australian dollar.
     Costs not denominated in Australian dollars are re-measured in Australian dollars, when recorded, at the prevailing exchange rates for the purposes of our financial statements. Consequently, fluctuations in the rates of exchange between the Australian dollar and non-Australian dollar currencies will affect our results of operations. An increase in the value of a particular currency relative to the Australian dollar will increase the Australian dollar reporting value for transactions in that particular currency, and a decrease in the value of that currency relative to the Australian dollar will decrease the Australian dollar reporting value for those transactions.
     The effect of foreign currency translation is reflected in our financial statements in the statements of changes in stockholders’ equity and is reported as accumulated translation reserve. At December 31, 2005, the impact of the foreign currency translation was an accumulated reserve of (A$94,785) compared to accumulated reserve balance of (A$142,886) at December 31, 2004. The fluctuations are caused by fluctuations in the exchange rate between the Australian dollar and the U.S. dollar. We have not entered into any hedging arrangements to mitigate the effects of currency fluctuations.
B. Liquidity and Capital Resources
     Overview
     We have incurred substantial losses since the formation of Metal Storm and anticipate incurring substantial additional losses over at least the next several years as we continue our research and development activities and conduct further trials of our technology. Our operations have been financed primarily from capital contributions by investors, interest income earned on cash and cash equivalents, and grants from government agencies.
     The following table sets forth our consolidated cash flows for the past two years.
                 
    Year ended December 31,  
    2005     2004  
    A$     A$  
Net cash used in operating activities
    (11,241,259 )     (11,236,655 )
Net cash used in investing activities
    (1,470,492 )     (311,499 )
Net cash (used in) provided by financing activities
    (1,760,025 )     18,603,071  
Effect of exchange rate changes on cash
    (1,959 )      
 
           
Net movement in cash and cash equivalents
    (14,473,735 )     7,054,917  
 
           
     Cash used in operating activities in each of the past two years consisted primarily of losses incurred in operations.
     In 2004, the net cash used in investing activities related primarily to the acquisition of property and equipment as well as a A$845,446 payment made in respect of a restricted deposit. In 2005, net cash used in investing activities consisted of the sale proceeds for the net assets of ProCam (A$2.3 million) as well as the purchase and sale of fixed interest securities.
     Our net cash provided by financing activities in 2004 related primarily to an offering of ordinary shares. In May 2004, we raised approximately A$21.5 million in a placement of ordinary shares to sophisticated and institutional investors outside the United States. In 2005, net cash used by financing activities consisted primarily of repayments of borrowings owed by ProCam as well as financing proceeds to fund insurance premiums of Metal Storm. In May 2006, we raised approximately A$2.7 million, net of transaction costs, from shareholders resident in Australia and New Zealand through a share purchase plan.
     Borrowings
     We had no borrowings until we assumed indebtedness of ProCam in connection with the acquisition of ProCam in December 2003. We had a short-term bank loan of A$578,392 resulting from this acquisition that expired in February 2004. In January 2004, a new line of credit was established that matured in January 2006, with an interest rate of 4.6% and offsetting interest earned on deposits at 2.5%. As of December 31, 2005, we had no outstanding loans.
     In June 2006, Metal Storm signed a Cash Advance Facility Agreement with Harmony Investment Fund Limited (an affiliate of Harmony Capital Partners Pte Limited) to establish a A$5 million short-term working capital secured loan facility. The working capital facility has an interest rate of 10% per annum on the drawn portion of the facility and an undrawn commitment fee of 2% per annum on the undrawn portion of the facility, payable quarterly on the last day of each calendar quarter. Prior to June 30, Harmony agreed to extend the first commitment fee payment period from June 30 to September 30, 2006. As a result, the first working capital facility commitment fee payment is not due until September 30, 2006. This facility is secured by all of Metal Storm’s present and future assets and expires in June 2007. Proceeds from the Renounceable Rights Offer discussed below must be used to repay any amounts outstanding under the working capital facility upon completion of the Rights Offer. In addition, 10,000,000 options to purchase ordinary shares of Metal Storm will be granted to Harmony Investment Fund

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upon completion of the Rights Offer as consideration for the working capital facility. As of July 14, 2006, we had not drawn any amount under the facility.
     Proposed New Financing
     In May 2006, Metal Storm announced an agreement with Harmony Capital Partners Pte Limited to facilitate and sub-underwrite a Renounceable Rights Offer of A$27.5 million in unsecured Convertible Notes with attaching Options that would be offered to shareholders resident in Australia and New Zealand. The issue price of the Convertible Notes is anticipated to be A$0.135 per Convertible Note, with each Convertible Note having a maturity date of August 2009 and an interest rate of 10% per year. Metal Storm may elect to defer payment of interest on the Convertible Notes during the first twelve months. Holders of Convertible Notes may elect, prior to the maturity date, to convert any portion of the amount outstanding under the Convertible Notes into ordinary shares of Metal Storm at a conversion price of the lesser of A$0.135 per ordinary share or 90% of the weighted average price per ordinary share over the 30 days prior to the conversion date. Holders of Convertible Notes would also be issued one Option to purchase an ordinary share of Metal Storm for each two Convertible Notes purchased, with a three year maturity and an exercise price of A$0.15. Harmony Capital Partners would also be issued 65,000,000 Options to purchase ordinary shares of Metal Storm at the completion of the Renounceable Rights Offer.
     In addition, Harmony Capital Partners would be granted the right to nominate one person to be appointed as a director of Metal Storm for so long as there are Convertible Notes outstanding. In July 2006, Metal Storm announced that Mr. John Nicholls has agreed to join our board of directors as Harmony’s nominee upon or shortly after the commencement of the Renounceable Rights Offer. The Renounceable Rights Offer is anticipated to commence in late July 2006 and close in August 2006 and is subject to certain conditions. There can be no assurance that this financing transaction will occur or that the final terms will be as proposed and, as a result, if Metal Storm will continue as a going concern.
     Other Material Commitments
     We had no material capital expenditures during the past two years and do not expect to incur any material capital expenditure in 2006.
     Future Cash Needs
     We expect that operating expenses will continue to be the principal use of our cash resources. We believe that our cash and cash equivalents plus our available-for-sale financial assets of A$5.1 million as at December 31, 2005, together with the cash raised through our share purchase plan in May 2006, will provide us with sufficient capital to fund our operations until late November 2006. Our working capital loan facility of A$5 million, signed in June 2006, would give us access to additional funds to continue operations until at least early May 2007. We plan to commence a Renounceable Rights Offer in July 2006 of A$27.5 million in unsecured Convertible Notes with attaching Options that is anticipated to close in August 2006 and is subject to certain conditions. There can be no assurance that this financing transaction will occur or that the final terms will be substantially the same as the preliminary terms.
     We will likely need to raise additional sources of funding and may seek it through public or private equity or debt financings. The sale of additional equity or convertible debt could result in dilution to our shareholders. Additional debt would result in increased expenses and could result in covenants that would restrict our operations.
C. Research and Development: Patents and Licenses
     Our primary activity since incorporation in 1994 has been the research and development of our technology. Expenditure on this activity was A$1.8 million and A$1.6 million for the years ended December 31, 2005 and 2004, respectively. Our policy is to focus our research on selected internal product development projects as well as external development programs under which we work in collaboration with other parties. See Item 4B “Information on Metal Storm — Business Overview”.
D. Trend Information
     We are a development stage company. Most of our technology requires further investment, research, development, testing and possibly regulatory approval prior to any commercial sales. We do not currently derive any revenue from the commercial sale of any applications of our technology. We cannot be sure of the extent to which the technology, or any products we develop, will be able to penetrate the potential markets and generate revenue. We believe that our future success depends on our ability to commercialize our technology. See Item 3D “Key Information — Risk Factors”.

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     Recent Pronouncements
     During 2005, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 151 Inventory Costs, an amendment of ARB No. 43, Chapter 4, No. 153 Exchanges of Non-Monetary Assets, an amendment of APB Opinion No. 29, No. 154 Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3, No.155 Accounting for Certain Hybrid Financial Instruments, and amendment of FASB Statements No. 133 and No. 140, and No. 156 Accounting for Servicing of Financial Assets, and amendment of FASB Statement No. 140.
     SFAS 151 and SFAS 153 are applicable to the fiscal years beginning after June 15, 2006. SFAS 155 and SFAS 156 are applicable for the fiscal years beginning after September 15, 2006.
     Metal Storm does not expect the effects of adopting the above Statements of Financial Accounting Standards on its consolidated financial position and the results of its operations will be material when such statements are adopted.
E. Off-Balance sheet arrangements
     Not applicable.
F. Tabular disclosure of contractual obligations
     The following table summarizes our contractual obligations and commitments as of December 31, 2005:
                                         
    Payments due by period
            Less than                   More than
    Total   1 year   1-3 years   3-5 years   5 years
    A$   A$   A$   A$   A$
Operating leases of Metal Storm
    1,553,972       468,067       588,033       497,872        
Other (1)
    687,044       515,287       171,757              
 
                                       
Total
    2,241,016       938,354       759,790       497,872              —  
 
                                       
 
(1)   Other includes an onerous lease for a property occupied by ProCam.
Refer to Notes 25 and 31 to the accompanying consolidated financial statements for further information on our contractual commitments.

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Item 6. Directors, Senior Management and Employees
A. Directors and Senior Management
     The following people comprise our board of directors and senior management:
     
Name   Position
Terence J. O’Dwyer
  Executive Chairman
General Wayne A. Downing
  Deputy Chairman
Bruce S. McComish
  Director
James M. Crunk
  Director
Dr. Peter D. Jonson
  Director
Ian A. Gillespie
  Chief Operating Officer
James D. MacDonald
  Chief Financial Officer and Company Secretary
George L. Bergeron III
  Chief Technology Officer
 
     Terence J. O’Dwyer. Mr. O’Dwyer, a chartered accountant in Australia, has been a director of Metal Storm since 1998 and was appointed Executive Chairman in April 2006. As Executive Chairman, Mr. O’Dwyer has assumed the day to day management of Metal Storm but, in line with our cost reduction strategy, he will not receive any compensation for this role. He is also the Independent Chairman of BDO Kendalls, a large Queensland accountancy firm of which he had been a partner for 28 years until his retirement in 2005. He is also a director of Bendigo Bank Limited and Qld Theatre Co. and is the Chairman of MFS Limited and Brumbys Bakeries Holdings Limited.
     General Wayne A. Downing (U.S. Army (retired)). Appointed as a director of Metal Storm in October 1999, General Downing resigned from the Board in October 2001 following his appointment as U.S. National Director and Deputy National Security Advisor for Combating Terrorism. Following completion of this service, he was re-appointed a director of Metal Storm in October 2002. General Downing retired from active service in the military in 1996 after a distinguished 34-year career in the U.S. Army. His career included commands in infantry, armored, airborne, special operation and joint units. General Downing culminated his career as Commander in Chief of the U.S. Special Operations Command, where he was responsible for all special operations forces in the U.S. Army, Navy and Air Force.
     Bruce S. McComish. Mr. McComish was appointed a director of Metal Storm in October 2004. He has extensive commercial experience in the Australian and international business communities, having held senior management positions for several Australian and international companies. He is a director of HFA Accelerator Plus Ltd and MFS Living and Leisure Group.
     James M. Crunk. Mr. Crunk was appointed as a Director in September 2005. He has almost 25 years experience in the U.S. aerospace, defense, manufacturing and telecommunication industries and has international experience in arranging and negotiating partnerships, joint ventures, strategic alliances, financing and major contracts. He is the CEO of Advanced Technology Ventures, Inc. a company providing services to both the commercial and government contracting industries. Previously, he was the Chief Financial Officer for a privately held government contractor, the Controller of a division of a large defense contractor and the Chief Financial Officer of various start-up companies.
     Dr. Peter D. Jonson. Dr. Jonson was appointed as a Director in February 2006. He has had government and commercial experience in leadership positions. He is a professional director and economist and spends a considerable part of his time directly or indirectly helping scientists and technologists produce commercial outcomes from their research. Dr. Jonson is Deputy Chairman of Pro Medicus Limited and is a director of Village Roadshow Limited and is chairman of Bionomics Ltd. Dr. Jonson is also Chairman of Australian Institute for Commercialisation, Australian Aerospace and Defense Innovations Ltd and the Australian Government’s Cooperative Research Centers Committee. He is Chairman Emeritus of the Melbourne Institute Advisory Board. He also held a number of senior positions as an economist with the Reserve Bank of Australia from 1972 to 1988.
     Ian A. Gillespie. Mr. Gillespie was appointed as Metal Storm’s General Manager in May 2003 and as Chief Operating Officer in August 2005. He is responsible for the overall management of the operations of Metal Storm as well as managing our investor relations and capital requirements and corporate affairs. Prior to joining Metal Storm, Mr. Gillespie was engaged in venture capital and private investment activities. Among his previous roles he held the position of Managing Director and CEO of Grow Force Australia Limited, and General Manager positions with Incitec Limited, Atlas Steels Limited and Wormald International Limited. He has held the position of Director with numerous public and private companies and is currently a director of Standfast Enterprises Ltd, Indigo Group Ltd and Rugby Resources International Pty Ltd. Mr. Gillespie is Fellow of the CEO Institute of Australia and a Member of the Australia Institute of Company Directors.

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     James D. MacDonald. Mr. MacDonald was appointed Chief Financial Officer and Company Secretary in 2004. Prior to joining Metal Storm, Mr. MacDonald held similar positions with Endeavor Foundation, a charitable organization that is one of the largest of its kind in Australia, from 2000 to 2004; Grow Force Australia Limited from 1996 to 2000; and Southern Cross Pumps and Irrigation from 1993 to 1996. He has also worked with Arnott’s Biscuits Limited and was Group Accountant-Australian Operations for Spicers Paper Limited (now Paperlinx Limited) from 1986 to 1990. Mr. MacDonald is a Certified Practicing Accountant and a Fellow of the Australian Institute of Company Directors and the CEO Institute of Australia.
     George L. Bergeron III. Mr. Bergeron was appointed Chief Technology Officer in 2004. Based in the United States, Mr. Bergeron leads Metal Storm’s team of engineers and scientific staff both in the United States and Australia. He is a specialist in mechanical and electronic systems design, power generation and material science. He has considerable background in Metal Storm’s technology from his previous roles at Science Applications International Corporation, where he held several senior positions, most recently as director of SAIC’s Technology Development Laboratory.
     Proposed New Director
     In May 2006, Metal Storm announced an agreement with Harmony Capital Partners Pte Limited to facilitate and sub-underwrite a Renounceable Rights Offer of A$27.5 million in unsecured Convertible Notes with attaching Options that would be offered to shareholders resident in Australia and New Zealand. In connection with the Renounceable Rights Offer, Harmony Capital Partners would be granted the right to nominate one person to be appointed as a director of Metal Storm for so long as there are Convertible Notes outstanding. In July 2006, Metal Storm announced that Mr. John Nicholls has agreed to join our board of directors as Harmony’s nominee upon or shortly after the commencement of the Renounceable Rights Offer. The Renounceable Rights Offer is anticipated to commence in late July 2006 and is subject to certain conditions. There can be no assurance that this financing transaction will occur or that the final terms will be as proposed.
     Mr. Nicholls has extensive experience in the Australian and international business communities with start-up and established companies, having held senior management positions and directorships for several Australian and international companies in the manufacturing, distribution, trading and merchant banking industries. He is a director of Chemeq Limited and Brandrill Limited, each of which is listed on the Australian Stock Exchange. He has extensive experience in multicultural environments as Chief Executive and as a Non Executive Director being continuously resident in Asia for 30 years prior to returning to Australia during the late 1990’s.
B. Compensation
     In 2005, the aggregate remuneration we paid and that accrued to our directors and executive officers was A$2,310,304. In accordance with Australian superannuation legislation, we contributed A$61,182 to superannuation funds for our directors and executive officers for their pension, retirement and other similar benefits in 2005. We employed approximately 12 U.S. residents during 2005.
     The remuneration and benefits paid to our directors and executive officers during 2005, on an individual basis, are set out in the table below.
                                                                                 
                    Share           Total
                                                    Based   Termination           Performance
            Primary Benefits   Post Employment   Payment   Benefits   Total   Related
            Salary &   Cash   Non   Super-   Retirement   Options            
            Fees   Bonus   Monetary   annuation   Benefits   (12)            
                            Benefits   (10) /Life &                        
                                    Medical                        
                                    Insurance                        
                                    (11)                        
            A$   A$   A$   A$           A$   A$   A$   %
Directors
                                                                               
T J O’Dwyer
            70,000                                           70,000        
W A Downing
    (1)(2)     110,111                               220,569             330,680        
B S McComish
            50,000                                           50,000        
D A Smith
    (3)(4)     278,123                   7,156                         285,279        
D L Alspach
    (5 )     75,000                                           75,000        
J M Crunk
    (6 )     27,015                                           27,015        
J M O’Dwyer
    (7 )                       23,523                   500,000       523,523        
 
                                                                               
Executives
                                                                               
I A Gillespie
    (8 )     223,104       146,000             21,031             17,349             407,484       35.8  
J D MacDonald
            184,759                   16,628             41,833             243,220        
G L Bergeron III
    (3 )     235,286                   17,560             23,844             276,690        
J C Chehansky
    (3)(9)     19,891                   1,522                         21,413        
Total
            1,273,289       146,000             87,420             303,595       500,000       2,310,304          

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1   In 2005, W A Downing entered into a call option agreement with J M O’Dwyer, Metal Storm’s major shareholder. Under this agreement, W A Downing has the option to acquire 2,000,000 of the shares owned and held by J M O’Dwyer if he holds office as a Director of Metal Storm for a continuous period of three years. The value of this right is to be amortized over the three year vesting period.
 
2   Directors’ fees of A$65,111 settled in cash with the remaining A$49,000 to be settled in options.
 
3   Paid in U.S. dollars.
 
4   Appointed CEO in February 2005, appointed Managing Director in May 2005 and resigned in April 2006.
 
5   Directors’ fees of A$30,000 settled in cash with the remaining A$45,000 to be settled in options. Resigned in July 2006.
 
6   Appointed in September 2005.
 
7   Resigned in February 2005.
 
8   Bonus for the 2004 financial year (approved and paid in the 2005 financial year) included A$100,000 settled in cash with the remaining A$46,000 settled in shares.
 
9   Appointed in December 2005 and resigned in May 2006.
 
10   Superannuation (Australia)
 
11   Life and medical insurance (USA)
 
12   Options are valued using the Black-Scholes model. See Note 18 to the accompanying consolidated financial statements.
     During the 2005 financial year the following options were granted as equity remuneration benefits to directors and executives. Options granted to directors were in respect to directors fees for the 2004 financial year. Options issued to executives were in accordance with employment contracts. These options were not issued as part of an incentive plan.
                                                         
                    Fair                   Total value of    
                    Value   Value of           options    
                    per   options           granted,    
                    option at   granted   Total value of   exercised and   % of remuneration
                    grant   during the   options lapsed   lapsed during   consisting of
                    date (1)   year   during the year   the year   options for the
    Grant Date   No.   A$   A$   A$   A$   year
Directors
                                                       
W A Downing
    24/05/05       450,000       0.03       13,500             13,500       100 %
D L Alspach
    24/05/05       675,000       0.03       20,250             20,250       100 %
J M O’Dwyer
    24/05/05       450,000       0.03       13,500             13,500       100 %
W A Owens
    24/05/05       150,000       0.03       4,500             4,500       100 %
D W Christman
    24/05/05       618,750       0.03       18,563             18,563       100 %
C A Vehlow
    24/05/05       225,000       0.03       6,750             6,750       1 %
 
                                                       
 
            2,568,750               77,063             77,063          
 
                                                       
 
                                                       
Executives
                                                       
I A Gillespie (2)
    01/01/04       62,500       0.28       17,500               17,500          
 
    01/01/04       62,500       0.28       17,500               17,500          
 
    01/01/04       62,500       0.29       18,125               18,125          
 
    01/01/04       62,500       0.29       18,125               18,125          
 
                                                       
 
            250,000               71,250             71,250       18 %
 
                                                       
 
                                                       
J D MacDonald (2)
    26/08/05       62,500       0.09       5,625               5,625          
 
    26/08/05       62,500       0.10       6,250               6,250          
 
    26/08/05       62,500       0.10       6,250               6,250          
 
    26/08/05       62,500       0.11       6,875               6,875          
 
    26/08/05       62,500       0.11       6,875               6,875          
 
                                                       
 
            312,500               31,875             31,875       13 %
 
                                                       
 
                                                       
G L Bergeron III (2)
    11/06/04       31,250       0.25       7,813               7,813          
 
    11/06/04       31,250       0.25       7,813               7,813          
 
    11/06/04       31,250       0.25       7,813               7,813          
 
    11/06/04       31,250       0.26       8,125               8,125          
 
                                                       
 
            125,000               31,564             31,564       11 %
 
                                                       
Total
            3,256,250               211,752             211,752          
 
                                                       
 
(1)   See Note 18 to the accompanying consolidated financial statements for a discussion of our share-based payment plan.
 
(2)   See Notes 29(b)(ii) and 31(c) to the accompanying consolidated financial statements for the portion of options value recognized as remuneration expense during the year.

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     Effective April 28, 2006, David A. Smith resigned his positions as Chief Executive Officer and member of the board of directors of Metal Storm pursuant to the terms of a Deed of Termination agreement. This agreement provides for separation payments aggregating US$182,000 (A$239,694) to be paid to Mr. Smith in consideration of the standard releases and indemnifications provided by him to Metal Storm. Pursuant to the agreement, Mr. Smith was also granted 625,000 options to purchase ordinary shares of Metal Storm exercisable at A$0.40 per option until June 30, 2011.
C. Board Practices
     Under our constitution, our board of directors is required to be comprised of at least three directors. As of December 31, 2005, our board was comprised of six directors. Our board is currently comprised of five directors. Our directors are elected to the board of directors for a three-year term and one-third of the directors retire by rotation at each annual general meeting of shareholders.
     The board of directors has established an Audit Committee that consists of three independent directors. Current members of our Audit Committee are Mr. Bruce S. McComish (Chairman of the Audit Committee), Mr. James Crunk and Dr. Peter Jonson.
     Under its charter, the Audit Committee:
    retains independent auditors and reviews and discusses the independence of the auditors;
 
    sets the engagement policies for the independent auditors;
 
    reviews and discusses the audit plan, the conduct of the audit and the audit results;
 
    reviews and discusses financial statements and disclosures;
 
    determines and administers internal audit procedures;
 
    reviews and discusses the systems of internal accounting controls;
 
    reviews and discusses the recommendations of independent auditors;
 
    approves related party transactions; and
 
    establishes procedures for complaints regarding financial statements or accounting policies.
     The Audit Committee invites external auditors to attend Audit Committee meetings where appropriate. The Audit Committee also meets to receive reports from the external auditors concerning any matters that arise in connection with the performance of their role, including the adequacy of internal controls.
     Our board of directors has established a Finance Committee that is intended to be an oversight body on capital raisings, mergers and acquisitions and the financial function of Metal Storm’s operations. Mr. McComish is Chairman and Mr. Crunk and Mr. O’Dwyer are members of the Finance Committee.
     The board of directors has also established a Remuneration Committee, whose members are: General Wayne A. Downing and Dr. Jonson. The board of directors’ remuneration objective is to motivate directors and management to pursue the long-term growth and success of Metal Storm within an appropriate control network.
     The Remuneration Committee reviews the compensation arrangements of all directors and executive officers on an annual basis and makes recommendations to the board. The Remuneration Committee reviews and assesses the appropriateness of compensation arrangements of directors and executive officers by reference to relevant employment market conditions and with regard to performance based on set key performance indicators. Executive bonuses are linked to the achievement of pre-determined key performance indicators, and can also be granted based on the discretion of the Remuneration Committee. In order to retain and attract executives of sufficient caliber to facilitate the efficient and effective management of our operations, the Remuneration Committee seeks the advice of external advisers in connection with the structure of remuneration packages. It is the Remuneration Committee’s policy that employment agreements are entered into with all executives.
     Remuneration packages contain the following key elements:
    salary/fees;
 
    benefits — including the provision of retirement and health benefits; and
 
    incentive schemes — including performance-related bonuses and share options under the discretionary share option plan.
     It is the Remuneration Committee’s policy that payment of equity based remuneration to executive and non-executive directors is subject to shareholder approval. Metal Storm operates a discretionary employee option plan to enable the board of directors to provide an incentive

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to and to reward, full time executives and employees for the role that they play in the future success of Metal Storm. Invitations to participate in the discretionary employee option plan are at the absolute discretion of the board of directors. Invitations to participate in the employee option plan specify the details of the invitation, such as maximum number of shares, date by which the application must be made by the invitee, the exercise price, any conditions attached to the exercise of the option and any disposal restrictions. The exercise price is not less than the market value of Metal Storm’s shares on the date determined by the board of directors, and the aggregate number of shares subject to options cannot exceed 5% of Metal Storm’s shares then on issue. There are also individual limits on the number of options that may be granted to employees and individual limits on the number of shares that may be allotted and issued to employees upon exercise of the options. The exercise period for the options granted under the employee option plan is the earliest of (a) the third anniversary of the date of grant of the option; (b) the date on which any special circumstances including death, disability, redundancy, retirement or cessation of employment arise; (c) a takeover, compulsory acquisition, reconstruction, amalgamation or liquidation; and ending on the earliest of (d) the date which is 2 days before the tenth anniversary of the date of grant; (e) the last day before the first anniversary of the date on which any special circumstance arises; and (f) the expiry of specified time frames set out in the employee option plan in relation to the circumstances in (c) above. An option lapses upon expiry of the exercise period, termination of the option holder’s employment otherwise than in a special circumstance, upon the option holder being adjudicated bankrupt, or any purported transfer, assignment or alienation of the options by the option holder. The board of directors may at any time cease making further offers or invitations, but the subsisting rights of options are not affected in such circumstances. Non-executive directors do not have service contracts with Metal Storm.
D. Employees
     As at December 31, 2005, we had 24 employees, including five executive managers (two in Brisbane, Australia and three in Arlington, Virginia), four senior managers, two engineering managers, nine engineers and four administrative personnel.
E. Share Ownership
     The following table sets forth the beneficial ownership of our directors and executive officers as of June 22, 2006:
                         
            Percentage    
    Number of   of   Number of
    Shares   Outstanding   Options
Name   Owned(1)   Shares   Owned(1)
Terence James O’Dwyer
    180,855 (2)     0.033 %      
Wayne A. Downing
    500,000       0.091 %     3,890,000 (3)
Bruce McComish
                 
James M. Crunk
                 
Peter D. Jonson
                 
Ian A. Gillespie
    89,396       0.016 %     1,100,000 (4)
James D. MacDonald
                500,000 (5)
George L. Bergeron III
                250,000 (6)
 
(1)   At June 22, 2006, the number of outstanding shares was 544,709,065 and the number of outstanding options (all unlisted) was 17,206,438, of which 418,750 were granted but not issued.
 
(2)   101,233 shares are owned by Mr. Terence J. O’Dwyer and Mrs. P.M. O’Dwyer, 79,622 shares are owned by Louclaben Pty Ltd in trust for the O’Dwyer Family Account.
 
(3)   Represents: (a) 2,500,000 unlisted options to purchase ordinary shares of Metal Storm that are exercisable only upon certain conditions on or before July 2, 2011 at an exercise price of A$0.01 per share (the purchase price for the 2,500,000 unlisted options was nil); (b) 450,000 unlisted options to purchase ordinary shares of Metal Storm on or before June 21, 2009 at an exercise price of A$0.40 per share (the purchase price for the 450,000 unlisted options was A$0.10); (c) 450,000 unlisted options to purchase ordinary shares on or before June 24, 2010; and (d) 490,000 unlisted options to purchase ordinary shared on or before April 28, 2011.

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(4)   Represents 600,000 unlisted options to purchase ordinary shares of Metal Storm on or before April 14, 2009. The remaining 500,000 options to purchase ordinary shares of Metal Storm are represented by eight tranches of 62,500 options expiring at quarterly intervals between March 31, 2009 and December 31, 2010. These options are identical in every other manner. The exercise price for these option is A$0.40 and no purchase consideration was provided.
 
(5)   Represents 500,000 options to purchase ordinary shares of Metal Storm, which are represented by eight tranches of 62,500 options expiring at quarterly intervals between December 31, 2009 and September 30, 2011. These options are identical in every other manner. The exercise price for these option is A$0.40 and no purchase consideration was provided.
 
(6)   Represents 250,000 options to purchase ordinary shares of Metal Storm, which are represented by eight tranches of 31,250 options expiring at quarterly intervals between September 4, 2009 and June 30, 2011. These options are identical in every other manner. The exercise price for these option is A$0.40 and no purchase consideration was provided.
     We can grant options to purchase our shares to our directors and employees under our constitution and under our discretionary share option scheme and under various employment agreements. See Item 10B “Additional Information — Our Constitution” for a summary of the provisions of our constitution relating to the issuance of options and Note 15 to the accompanying consolidated financial statements and Item 6B “Directors, Senior Management and Employees - Compensation” for a summary of the terms of our various option schemes.

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Item 7. Major Shareholders and Related Party Transactions
A. Major Stockholders
     The following table sets out details, as of June 22, 2006, of entities beneficially holding more than five percent of the ordinary shares of Metal Storm.
                 
    Ordinary Shares Beneficially Owned
    as at June 22, 2006
    Number of   Percent of
Name   Shares owned   Class
James Michael O’Dwyer
    199,804,908 (1)     36.68 %
 
(1)   131,554,681 shares are owned by Mr. J.M. O’Dwyer, 68,250,122 shares are owned by O’Dwyer Investments Pty Ltd as trustee for the O’Dwyer Family Discretionary Trust and 105 shares owned by Rhonda Clare O’Dwyer in trust for Mr. J.M. O’Dwyer.
     In February 2005, Mr J.M. O’Dwyer indicated his intention to sell half of his shareholdings. Since then he has sold no shares. He has informed us that it remains his intention to continue to deal with any potential sale on a basis that in his opinion will not be detrimental to Metal Storm.
     A former major shareholder, Charter Pacific Corporation Limited, reduced its shareholding over the past few years: it owned 26.9% of our ordinary shares at June 30, 2002, 9.65% at May 4, 2004 and, since October 20, 2004, less than 5%.
     As at June 22, 2006, there were 9,776 record holders of ordinary shares, of which 9,607 represented Australian record holders holding approximately 94% of our outstanding ordinary shares.
B. Related Party Transactions
     In February 2005, Metal Storm entered into a Separation Agreement with its major shareholder James M. O’Dwyer pursuant to which he was paid a retirement benefit of A$500,000 in recognition of his services to Metal Storm as its founder, a director and chief executive officer during our early years and, in more recent years, as an employee and consultant. In addition, Mr. O’Dwyer agreed to assign to Metal Storm certain intellectual property rights and agreed to certain non-competition arrangements.
     During 2004 and 2005, Metal Storm utilized the services of investment bank BBY Limited, of which Bruce McComish was a Director until April 2005. In late 2005, after Mr. McComish resigned as a Director of BBY, Metal Storm paid fees of A$100,000 to BBY for corporate advisory services provided in the second half of 2005. In 2004, Metal Storm paid A$23,606 in fees to BBY for corporate advisory services.
     General Wayne Downing entered into a call option agreement with Mr. J M O’Dwyer on October 10, 2003 under which General Downing may call for the transfer of up to 2,000,000 existing shares to him at an exercise price of A$0.40 per share. The call option is exercisable on one or more occasions until October 10, 2013, but only if certain conditions are satisfied, including that, except in certain limited circumstances, General Downing remains a director of Metal Storm until October 10, 2006.
C. Interest of Experts and Counsel
     Not applicable.
Item 8. Financial Information
A. Consolidated Financial Statements and Other Financial Information
     Our financial statements are included in Item 17 “Financial Statements”.
Export Sales
     Not applicable.

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Legal Proceedings
     We are not a party to any legal proceedings.
Dividends
     Until we make a profit our directors will not be able to recommend that any dividends be paid to our stockholders. Our directors will not resolve a formal dividend policy for us until we generate profits. Our directors’ current intention is to reinvest our income in the continued development and operation of our business.
B. Significant Changes
     Not applicable.

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Item 9. The Offer and Listing
A. Listing Details
     Australian Stock Exchange
     Our ordinary shares were listed and posted for trading on the Australian Stock Exchange (symbol “MST”) in 1999. The following table sets forth for the periods indicated the reported low and high bid prices and the average daily trading volume for our ordinary shares as quoted on the Australian Stock Exchange. All figures are in Australian dollars.
                         
                    Average
    Price Per   Daily
    Ordinary Share   Trading
    High   Low   Volume
Year Ended   A$   A$        
December 31, 2005
                       
First Quarter
  $ 0.27     $ 0.17       1,025,253  
Second Quarter
  $ 0.18     $ 0.10       689,969  
Third Quarter
  $ 0.31     $ 0.12       1,755,116  
Fourth Quarter
  $ 0.29     $ 0.19       529,162  
December 31, 2004
                       
First Quarter
  $ 0.50     $ 0.41       318,003  
Second Quarter
  $ 0.66     $ 0.37       2,927,093  
Third Quarter
  $ 0.38     $ 0.24       1,463,448  
Fourth Quarter
  $ 0.33     $ 0.20       2,925,739  
December 31, 2003
                       
Annual
  $ 0.68     $ 0.32       273,307  
December 31, 2002
                       
Annual
  $ 1.58     $ 0.42       254,020  
December 31, 2001
                       
Annual
  $ 2.11     $ 0.80       191,255  
                         
                    Average
    Price Per   Daily
    Ordinary Share   Trading
    High   Low   Volume
Month Ended   A$   A$        
June 30, 2006
  $ 0.17     $ 0.12       494,447  
May 31, 2006
  $ 0.19     $ 0.14       989,930  
April 30, 2006
  $ 0.21     $ 0.15       685,868  
March 31, 2006
  $ 0.27     $ 0.19       485,450  
February 28, 2006
  $ 0.28     $ 0.22       862,248  
January 31, 2006
  $ 0.23     $ 0.18       846,872  

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Nasdaq SmallCap Market
     Our ordinary shares in the form of ADRs were listed for trading on the Nasdaq SmallCap Market (symbol “MTSX”) on December 12, 2001. Each ADR represents the right to receive 20 ordinary shares. The following table sets forth for the periods indicated the high and low closing sales prices in U.S. dollars and the average daily trading volume of our ADRs as reported on the Nasdaq SmallCap Market.
                         
                    Average
    Price Per   Daily
    ADR   Trading
Year Ended   High   Low   Volume
    US$   US$        
December 31, 2005
                       
First Quarter
  $ 4.26     $ 2.55       99,102  
Second Quarter
  $ 3.00     $ 1.75       41,994  
Third Quarter
  $ 4.84     $ 1.81       130,117  
Fourth Quarter
  $ 4.70     $ 2.76       43,002  
December 31, 2004
                       
First Quarter
  $ 8.00     $ 6.40       7,685  
Second Quarter
  $ 14.47     $ 4.90       682,510  
Third Quarter
  $ 5.60     $ 3.50       90,903  
Fourth Quarter
  $ 5.74     $ 2.95       250,094  
December 31, 2003
                       
Annual
  $ 8.53     $ 3.97       3,702  
December 31, 2002
                       
Annual
  $ 15.77     $ 4.90       3,877  
December 31, 2001
                       
Annual
  $ 28.10     $ 12.85        
                         
                    Average
    Price Per   Daily
    ADR   Trading
Month Ended:   High   Low   Volume
    US$   US$        
June 30, 2006
  $ 2.58     $ 1.75       23,160  
May 31, 2006
  $ 3.05     $ 2.23       51,082  
April 30, 2006
  $ 3.04     $ 2.06       38,034  
March 31, 2006
  $ 3.80     $ 2.82       25,477  
February 28, 2006
  $ 4.04     $ 3.00       74,192  
January 31, 2006
  $ 3.66     $ 2.32       94,302  
B. Plan of Distribution
     Not applicable.
C. Markets
     Our ordinary shares are listed on the Australian Stock Exchange under the symbol “MST” and on the Nasdaq SmallCap Market in the form of American Depositary Receipts under the symbol “MTSX”.
Exemptions from certain Nasdaq Corporate Governance Rules
     Exemptions from the Nasdaq corporate governance standards are available to foreign private issuers such as Metal Storm when those standards are contrary to a law, rule or regulation of any public authority exercising jurisdiction over such issuer or contrary to generally accepted business practices in the issuer’s country of domicile. In connection with Metal Storm’s Nasdaq SmallCap Market Listing Application, Nasdaq granted Metal Storm exemptions from certain corporate governance standards that were contrary to the laws, rules, regulations or generally accepted business practices in Australia. These exemptions and the practices followed by Metal Storm during the fiscal year ended December 31, 2005 are described below.

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  Metal Storm was exempt from Nasdaq’s audit committee composition requirements until July 31, 2005. The recommendations set forth in the Australian Stock Exchange Corporate Governance Principles relating to composition of audit committees differ to Nasdaq’s audit committee composition requirements. For example, the Corporate Governance Principles recommend that an audit committee comprise at least three members and that at least one member be independent, whereas Nasdaq requires that all members of the committee be independent. From January through July 2005, Metal Storm had an audit committee consisting of two directors, both of whom were independent within the meaning of the Nasdaq rules, and appointed a third member who was an independent director at the end of July 2005.
 
  Metal Storm was exempt from Nasdaq’s independence requirements for a majority of the board of directors. The Australian Stock Exchange Listing Rules did not require Metal Storm to have a majority of independent directors on the board during 2005. During most of the fiscal year ended December 31, 2005, Metal Storm did, however, have a majority of directors who were “independent” as defined in the Australian Stock Exchange Corporate Governance Principles, which definition differs from Nasdaq’s definition. Accordingly, because Australian law and generally accepted business practices in Australia regarding director independence differ to Nasdaq’s independence requirements, Metal Storm claimed this exemption in 2005.
 
  Metal Storm was exempt from Nasdaq’s quorum requirements applicable to meetings of shareholders. Consistent with Australian law, Metal Storm’s constitution provides that five shareholders present shall constitute a quorum for a general meeting. Nasdaq requires that an issuer provide for a quorum as specified in its by-laws for any meeting of the holders of common stock, which quorum may not be less than 33 1/3 % of the outstanding shares of an issuer’s voting common stock. Accordingly, because applicable Australian law and rules governing quorums at shareholder meetings differ to Nasdaq’s quorum requirements, Metal Storm claimed this exemption in 2005.
 
  Metal Storm was exempt from the Nasdaq requirement that an issuer’s auditors be subject to a “peer review.” Neither Australian law nor the Australian Stock Exchange Listing Rules required “peer review” of independent public accountants during 2005. Accordingly, Metal Storm claimed this exemption in 2005.
 
  Metal Storm was exempt from the Nasdaq requirement that issuers obtain shareholder approval prior to the issuance of securities in connection with the establishment or amendment of certain stock option, purchase or other compensation plans. Applicable Australian law and rules differ to the Nasdaq requirements, with the Australian Stock Exchange Listing Rules providing generally for prior shareholder approval in numerous circumstances, including (i) issuance of equity securities exceeding 15% of the issued share capital of the company in any 12 month period (but in determining the 15% limit, securities issued under an exception to the rule or with shareholder approval are not counted), (ii) issuance of equity securities to related parties (as defined in the Australian Stock Exchange Listing Rules), and (iii) directors or their associates acquiring securities under an employee incentive plan. Generally accepted business practices in Australia also provide for plans involving the issue of shares to directors and employees being capped at no more than 5% of the total number of shares on issue. Metal Storm’s Discretionary Share Option Scheme applies this 5% cap. Due to differences between Australian law and rules and the Nasdaq shareholder approval requirements, Metal Storm claimed this exemption in 2005.
D. Selling Stockholders
     Not applicable.
E. Dilution
     Not applicable.
F. Expenses of the Issue
     Not applicable.
Item 10. Additional Information
A. Share Capital
     Not applicable.

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B.   Our Constitution
     We are a public company limited by shares registered by the Australian Securities and Investments Commission (“ASIC”). We were registered on April 13, 1994 and our Australian company number is 064 270 006. Subject to the Australian Stock Exchange Listing Rules and the Australian Corporations Act, the rights that attach to our shares are detailed in our constitution. Our current constitution was adopted on May 14, 1999. Under Australian law, a company has the legal capacity and powers of an individual both inside and outside Australia.
     The material provisions of our constitution are summarized below. This summary is not intended to be complete, nor to constitute a definitive statement of the rights and liabilities of our stockholders and is qualified in its entirety by reference to the constitution, which is available on request.
Directors
  Interested Directors
     A director may not vote in respect of any contract or arrangement in which the director has, directly or indirectly, any material interest according to our constitution. Such director may not be counted in the quorum present at the meeting and if the director does vote, such vote may not be counted. Either or both of these prohibitions may be relaxed or suspended to any extent by resolution passed at a general meeting of stockholders.
     The Australian Corporations Act prohibits directors of companies listed on the Australian Stock Exchange from voting on matters in which they have a material personal interest, requires disclosure of such interest to stockholders, and requires stockholders’ approval of any provision of related party benefits.
   Directors’ Compensation
     Our directors are paid remuneration for their services as directors, which is determined in a general meeting of stockholders. The aggregate, fixed sum for directors’ remuneration is to be divided among the directors in such proportion as the directors themselves agree, and in accordance with our constitution. The fixed sum remuneration for directors may not be increased except at a general meeting of stockholders and the particulars of the proposed increase are required to have been provided to stockholders in the notice convening the meeting.
     Pursuant to our constitution any director who devotes special attention to our business or who otherwise performs services which in the opinion of our board of directors are outside the scope of the ordinary duties of a director, or who at the request of the board of directors engages in any journey related to our business, may be paid extra remuneration which is determined by the board.
     In addition to other remuneration provided in our constitution, all directors are entitled to be paid by us for reasonable travel accommodation and other expenses incurred by the directors in attending company meetings, board meetings, committee meetings or while engaged on our business.
     Additionally in accordance with our constitution, a director may be paid a retirement benefit as determined by the board of directors in accordance with the Australian Corporations Act and the Australian Stock Exchange Listing Rules.
   Borrowing Powers Exercisable by Directors
     Pursuant to our constitution, the management and control of our business affairs are vested in our board of directors. The board has the powers to raise or borrow money, guarantee the debts or obligations of any person and enter into any other financial arrangement, in each case in the manner and on the terms it thinks fit. The board may also charge any of our property or business or any uncalled capital and may issue debentures or give any other security for any of our debts, liabilities or obligations or of any other person, in each case, in the manner and on terms it deems fit.
   Retirement of directors
     Pursuant to our constitution, one third of directors other than the director who is the managing director, must retire from office at every annual general meeting. If the number of directors is not a multiple of three then the number nearest to but not less than one third must retire from office. The directors who retire in this manner are required to be the directors or director longest in office since last being elected. A director, other than the director who is a managing director, must retire from office at the conclusion of the third annual general meeting after which the director was elected.
     There are no requirements in our constitution regarding the retirement of directors at any particular age. The Australian Corporations Act, however, requires that directors retire at the conclusion of the first annual general meeting after a director reaches age 72. A person who has reached age 72 may by special resolution of our stockholders be appointed or re-appointed as a director, provided the notice of meeting and the resolution appointing such director states such director’s age.

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   Share Qualifications
     There are no requirements under our constitution or elsewhere for directors to own our shares in order to qualify as directors.
Rights and Restrictions on Classes of Shares
     Subject to the Australian Corporations Act and the Australian Stock Exchange Listing Rules, rights attaching to our shares are detailed in our constitution. Our constitution provides that any of our shares may be issued with preferred, deferred or other special rights, whether in relation to dividends, voting, return of share capital, payment of calls or otherwise as the board of directors may from time to time determine. Except as provided by contract or by our constitution to the contrary, all unissued shares are under the control of the board which may grant options on the shares, allot or otherwise dispose of the shares on the terms and conditions and for the consideration it deems fit. Currently our outstanding share capital consists of only one class of ordinary shares.
   Dividend Rights
     The board may from time to time determine to pay dividends to stockholders. All unclaimed dividends may be invested or otherwise made use of by the board for our benefit until claimed or otherwise disposed of in accordance with our constitution.
   Voting Rights
     Under our constitution, each stockholder has one vote determined by a show of hands at a meeting of the stockholders. On a poll vote each stockholder shall have one vote for each fully paid share and a fractional vote for each share which is not fully paid, such fraction being equivalent to the proportion of the amount which has been paid to such date on that share. Under Australian law, stockholders are not permitted to approve corporate matters by written consent. Our constitution does not provide for cumulative voting.
   Right to Share in our Profits
     Pursuant to our constitution, our stockholders are entitled to participate in our profits only by payment of dividends. The board may from time to time determine to pay dividends to the stockholders, however no dividend is payable except out of our profits. A declaration by the board as to the amount of our profits is conclusive.
   Rights to Share in the Surplus in the Event of Liquidation
     Our constitution provides for the right of stockholders to participate in a surplus in the event of our liquidation. In certain circumstances, any division may be otherwise than in accordance with the legal rights of the contributories, and in particular, any class may be given preferential or special rights or may be excluded altogether or in part from participation in a surplus in the event of liquidation. In the case of any division otherwise than in accordance with the legal rights of the contributories, any contributory who would be prejudiced by the division has a right to dissent and has ancillary rights, as if the determination were a special resolution passed pursuant to the Australian Corporations Act relating to the sale or transfer of our assets by a liquidator or in a voluntary winding up.
   Redemption Provisions
     There are no redemption provisions in our constitution in relation to ordinary shares. Under our constitution and subject to the Australian Corporations Act, any preference shares may be issued on the terms that they are, or may at our option be, liable to be redeemed.
   Sinking Fund Provisions
     There are no sinking fund provisions in our constitution in relation to ordinary shares.

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        Liability for Further Capital Calls
     According to our constitution, the board may make any calls from time to time upon stockholders in respect of all monies unpaid on shares, subject to the terms upon which any of the shares have been issued. Each stockholder is liable to pay the amount of each call in the manner, at the time, and at the place specified by the board. Calls may be made payable by installment.
     Provisions Discriminating Against Holders of a Substantial Number of Shares
     There are no provisions under our constitution discriminating against any existing or prospective holders of a substantial number of our shares.
Variation of Share Rights
     Our constitution provides that, unless otherwise provided by the terms of issue of the shares of such class, the rights attaching to any class of shares may, subject to the Australian Stock Exchange Listing Rules, be varied with the consent in writing of members with at least 75% of the votes in the class or with the sanction of a special resolution passed at a separate meeting of the holders of the shares of such class. Our constitution also provides that the rights conferred upon holders of shares of any class issued with preferred or other rights are, unless otherwise expressly provided by the terms of issue of the shares of that class, deemed not to be varied by the creation or issue of further shares ranking equally with the first mentioned shares. These conditions are not more significant than required by the Australian Corporations Act.
General Meetings of Stockholders
     General meetings of stockholders may be called by the board of directors. Except as permitted under the Australian Corporations Act, stockholders may not convene a meeting. Under the Australian Corporations Act, stockholders with at least 5% of the votes which may be cast at a general meeting may call and arrange to hold a general meeting. The Australian Corporations Act requires the directors to call and arrange to hold a general meeting on the request of stockholders with at least 5% of the votes that may be cast at a general meeting or at least 100 stockholders who are entitled to vote at the general meeting. Twenty-eight days’ notice of the proposed meeting of our stockholders is required under the Australian Corporations Act.
     According to our constitution, the chairman of the general meeting may refuse admission to or exclude from the meeting, any person who is in possession of a picture recording or sound recording device, in possession of a placard or banner, in possession of an object considered by the chairman to be dangerous, offensive or liable to cause disruption, any person who refuses to produce or permit examination of any object, any person who behaves or threatens to behave in a dangerous, offensive or destructive manner, or any person who is not a director or one of our auditors, one of our stockholders or a proxy, attorney or representative of one of our stockholders.
Foreign Ownership Regulation
     There are no limitations on the rights to own securities imposed by our constitution. However, acquisitions and proposed acquisitions of shares in Australian companies may be subject to review and approval by the Australian Federal Treasurer under the Foreign Acquisitions and Takeovers Act of 1974. Generally this Act applies to acquisitions or proposed acquisitions:
  (a)   by a foreign person, as defined in the Foreign Acquisitions and Takeovers Act, or associated foreign persons which would result in such persons having an interest in 15% or more of the issued shares of, or control of 15% or more of the voting power in, an Australian company, and
 
  (b)   by a non-associated foreign person which would result in such foreign person having an interest in 40% or more of the issued shares of, or control of 40% or more of the voting power in, an Australian company.
     The Australian Federal Treasurer may prevent a proposed acquisition in the above categories or impose conditions on such acquisition if the Treasurer is satisfied that the acquisition would be contrary to the national interest. If a foreign person acquires shares or an interest in shares in an Australian company in contravention of the Act, the Australian Federal Treasurer may order the divestiture of such person’s shares or interest in shares in the company. The Australian Federal Treasurer may order divestiture pursuant to the Act if he determines that the acquisition has resulted in that foreign person, either alone or together with other non-associated or associated foreign persons, controlling the company and that such control is contrary to the national interest.
Merger, Acquisition or Restructure
     Our constitution indicates that where offers to purchase our shares have been made under a proportional take-over scheme, we are prohibited from registering a transfer which would give effect to the contract resulting from the acceptance of such an offer unless and until a resolution to approve the proportional takeover scheme is approved at a meeting by the persons entitled to vote on such resolution. The

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offeror or an associate of the offeror is not entitled to vote on such resolution. A person, other than an offeror or associate of the offeror, who, as at the end of the day in which the first offer under the proportional takeover scheme was made, held shares in that class of shares, is entitled to one vote for each of the shares held in that class.
Ownership Threshold
     There are no provisions in our constitution that require a stockholder to disclose ownership above a certain threshold. The Corporations Act 2001, however, requires a substantial stockholder to notify us and the Australian Stock Exchange once a 5% interest in our shares is obtained. Further, once a stockholder owns a 5% interest in us, such stockholder must notify us and the Australian Stock Exchange of any increase or decrease of 1% or more in its holding in our shares.
Conditions for Change of Capital
     There are no conditions imposed by our constitution relating to changes in our capital which are more stringent than are required by the Australian Corporations Act.
Stock Issues and Takeover Attempts
     We are governed by the Australian Corporations Act which provides stockholders with broad protection in relation to takeovers, including:
    that the acquisition of control over voting shares takes place in a efficient, competitive and informed market;
 
    that stockholders have enough information to assess the merits of a proposal; and
 
    that stockholders all have a reasonable and equal opportunity to participate in any benefits accruing to the stockholders through any proposal under which a person would acquire a substantial interest.
     Further, subject to limited exceptions provided in the Australian Stock Exchange Listing Rules, we must not issue or agree to issue shares, without the approval of holders of our ordinary shares, for three months after we are told in writing that a person is making or proposes to make, a takeover for our shares.
     The exceptions to the listing rule are as follows:
    an issuance or agreement to issue which we have notified the Australian Stock Exchange of before we are told a person is making or proposes to make a takeover for our shares;
 
    an issuance to our ordinary stockholders on a pro-rata basis;
 
    an issuance made due to an exercise of rights of conversion already in existence;
 
    an issuance by us as consideration for an off-market takeover bid made by us where we are required to comply with the provisions of the Australian Corporations Act;
 
    an issuance under a dividend stock distribution plan that is in operation before we are told a person is making or proposes to make a takeover for our shares; and
 
    if there is an agreement to issue shares and such agreement is conditional on ordinary stockholders approving the issuance before the issuance is made.
Access to and Inspection of Documents
     Inspection of our records is governed by the Australian Corporations Act. Any person has the right to inspect our company registers on payment of a fee. Stockholders are not required to pay a fee for inspection. Any person may obtain copies of a register or any part of the register upon payment of a fee as prescribed by us. Further, we must ensure that the minute books for the meetings of our stockholders are open for inspection to our stockholders free of charge. Other corporate records including minutes of directors meetings, financial records and other documents are not open for inspection by stockholders. However, a stockholder may apply to a court to make an order for inspection of our books, if the applicant stockholder is acting in good faith and the inspection is made for a proper purpose.
CHESS
     We participate in the Clearing House Electronic Sub-Register System, known as CHESS, which is maintained by the CHESS Securities Clearing House pursuant to the Australian Stock Exchange Listing Rules and the Securities Clearing House business rules. CHESS is an electronic transfer and settlement system, with no requirement for paper transfer documents. Accordingly, the legal registered record

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of holding balances for our CHESS-approved shares are recorded on either of the electronic CHESS sub-register or the electronic issuer sponsored sub-register, which together form the complete company register. We do not issue share certificates to stockholders. Instead, we provide stockholders with a holding statement (similar to a bank account statement) that sets out the number of ordinary shares registered in each stockholder’s name. This statement also advised stockholders of their holder identification number or stockholder reference number and relevant particulars. If a shareholding changes during any month, stockholders will receive a statement after the end of that month. Stockholders may also request statements at any other time (subject to payment of a small administration fee).
C. Material Contracts
     Asset Purchase Agreement for the Sale of ProCam
     Effective June 1, 2005, Metal Storm entered into an Asset Purchase Agreement with Monroe Machined Products, Inc. (“MMP”) for the sale of the ProCam business to MMP. Under the agreement, MMP purchased the assets and current order backlog of ProCam for US$1.3 million (A$1.76 million), plus an additional amount to acquire accounts receivable, inventory and assumed the accounts payable liabilities of ProCam’s precision machinery facility.
     Cash Advance Facility Agreement
     In June 2006, Metal Storm signed a Cash Advance Facility Agreement with Harmony Investment Fund Limited (an affiliate of Harmony Capital Partners Pte Limited) to establish a A$5 million short-term working capital secured loan facility. The working capital facility has an interest rate of 10% per annum on the drawn portion of the facility and an undrawn commitment fee of 2% per annum on the undrawn portion of the facility, payable quarterly on the last day of each calendar quarter. Prior to June 30, Harmony agreed to extend the first commitment fee payment period from June 30 to September 30, 2006. As a result, the first working capital facility commitment fee payment is not due until September 30, 2006. This facility is secured by all of Metal Storm’s present and future assets and expires in June 2007. Proceeds from the Renounceable Rights Offer discussed above must be used to repay any amounts outstanding under the working capital facility upon completion of the Rights Offer. In addition, 10,000,000 options to purchase ordinary shares of Metal Storm will be granted to Harmony Investment Fund upon completion of the Rights Offer as consideration for the working capital facility. As of July 14, 2006, we had not drawn any amount under the facility.
D. Exchange Controls
     The Australian dollar is convertible into U.S. dollars at freely floating rates. There are no legal restrictions on the flow of Australian dollars between Australia and the United States. The Commonwealth of Australia has, however enacted laws to make effective the United Nations Security Council resolutions that impose a freeze on financial assets and foreign exchange dealings with certain persons and entities. In addition, transactions involving the transfer of funds or payments to, by the order of, or on behalf of prescribed entities, or any undertaking owned or controlled directly or indirectly, by prescribed entities, are not permitted without the specific approval of the Reserve Bank of Australia.
E. Taxation
     The following is a summary of certain material U.S. federal income tax and Australian tax consequences to U.S. holders, as defined below, of the acquisition, ownership and disposition of American Depositary Shares (“ADSs”) or ordinary shares and is based on the laws in force as at the date of this annual report. Holders are advised to consult their tax advisors concerning the overall tax consequences of the acquisition, ownership and disposition of ADSs or ordinary shares in their particular circumstances. This discussion is not intended, and should not be construed, as legal or professional tax advice. This discussion relies in part on representations by the depositary in the deposit agreement and related documents and the assumption that each obligation in the deposit agreement and related documents will be performed in accordance with their terms.
U.S. Federal Income Tax Considerations
     In this section, we discuss certain material U.S. federal income tax considerations applicable to an investment in ADSs, which are evidenced by American Depositary Receipts (“ADRs”), or ordinary shares by a U.S. holder, as defined below, that will hold the ADSs or ordinary shares as capital assets within the meaning of the Internal Revenue Code of 1986, as amended (the “Code”). We do not discuss any tax considerations that may apply to holders subject to special tax rules, such as banks, insurance companies, dealers in securities or currencies, tax-exempt entities, persons subject to the alternative minimum tax, persons that hold ADSs or ordinary shares as a position in a straddle or as part of a hedging, constructive sale or conversion transaction for U.S. federal income tax purposes, persons that have a functional currency other than the U.S. dollar, persons that own 10% or more of our equity or persons that are not U.S. holders.

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     This section is based on the Code, income tax regulations issued under the Code, and judicial and administrative interpretations of the Code and the income tax regulations, all as of the date of this annual report. All of the foregoing are subject to change at any time, and any change could be retroactive.
     In this section, a “U.S. holder” means a beneficial owner of ADSs or ordinary shares that is, for U.S. federal income tax purposes:
    an individual who is a citizen or resident of the United States;
 
    a corporation, or other entity treated as a corporation for U.S. federal income tax purposes, created or organized in or under the laws of the United States or any state thereof or the District of Columbia;
 
    an estate the income of which is subject to U.S. federal income taxation regardless of its source; or
 
    a trust the administration of which is subject to the primary supervision of a court in the United States and for which one or more U.S. persons have the authority to control all substantial decisions.
     If a partnership holds ADSs or ordinary shares, the U.S. federal income tax treatment of a partner generally will depend on the status of the partner and the activities of the partnership. Partners of partnerships that will hold ADSs or ordinary shares should consult their tax advisors.
     You should consult your tax advisor with respect to the U.S. federal, as well as state, local and non-U.S., tax consequences to you of an investment in ADSs or ordinary shares.
   Ownership of ADSs in General
     A beneficial owner of ADSs will be treated as the beneficial owner of the ordinary shares represented by such ADSs for U.S. federal income tax purposes.
   Dividends
     Subject to the passive foreign investment company rules, discussed below, U.S. holders will include as dividend income any distributions of cash or property, other than certain pro rata distributions of ordinary shares, with respect to ADSs or ordinary shares to the extent the distributions are made from our current or accumulated earnings and profits, as determined for U.S. federal income tax purposes. A U.S. holder will include the dividend income at the time of receipt, which, for a holder of ADSs, generally will be the date of receipt by the depositary. To the extent, if any, that the amount of any distribution by us exceeds our current and accumulated earnings and profits, as so determined, it will be treated first as a tax-free return of the U.S. holder’s tax basis in the ADSs or ordinary shares and thereafter as capital gain. Dividends paid by us will not be eligible for the dividends-received deduction generally allowed to U.S. corporate stockholders.
     For taxable years beginning before January 1, 2011, dividends received by an individual from a “qualified foreign corporation” are eligible for preferential rates of taxation. A “qualified foreign corporation” generally does not include any foreign corporation that is a passive foreign investment company for the taxable year in which the dividend is paid or for the preceding taxable year. Accordingly, because we will likely be a passive foreign investment company for 2006 (as discussed below), we likely will not be a qualified foreign corporation for 2006 or 2007. If in subsequent taxable years we were eligible to be a qualified foreign corporation, then our dividends generally would be eligible for the preferential tax rates, except to the extent that the individual (1) holds a share of stock for 60 days or less during the 120-day period beginning 60 days before the ex-dividend date (or, in the case of certain preferred stock, 90 days or less during the 180-day period beginning 90 days before the ex-dividend date) as measured under Section 246(c) of the Code, (2) is under an obligation (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property or (3) elects to treat the dividend as investment income for purposes of determining the amount of deductible investment interest under Section 163(d)(4)(B) of the Code. Further, if an individual receives, with respect to any share of stock, an extraordinary dividend (within the meaning of Section 1059(c) of the Code) eligible for the preferential tax rates, any loss on a subsequent sale of the stock is treated as a long-term capital loss to the extent of the extraordinary dividend.
     Includible distributions paid in Australian dollars, including any Australian withholding taxes, will be included in the gross income of a U.S. holder in a U.S. dollar amount calculated by reference to the exchange rate in effect on the date of receipt, regardless of whether the Australian dollars are converted into U.S. dollars at that time. If Australian dollars are converted into U.S. dollars on the date of receipt, a U.S. holder generally should not be required to recognize any foreign exchange gain or loss.
     Dividends received by a U.S. holder with respect to ADSs or ordinary shares will be treated as foreign source income, which may be relevant in calculating the holder’s foreign tax credit limitation. The limitation on foreign taxes eligible for credit is calculated separately with respect to specific classes of income. For this purpose, dividends paid with respect to ADSs or ordinary shares will generally constitute “passive income” or “financial services income” for taxable years beginning on or before December 31, 2006, and as “passive category income”, or in certain cases “general category income”, for taxable years beginning after December 31, 2006.

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     Subject to certain complex limitations, a U.S. holder generally will be entitled to a credit against its U.S. federal income tax liability or a deduction in computing its U.S. federal taxable income in respect of any Australian taxes withheld by us.
     You should consult your tax advisor as to the consequences of Australian withholding taxes and the availability of a foreign tax credit or deduction. See “Australian Tax Considerations—Taxation of Dividends.”
   Sale or Exchange of ADSs or Ordinary Shares
     Subject to the passive foreign investment company rules, discussed below, a U.S. holder generally will recognize gain or loss on a disposition, including a sale, exchange or redemption, of ADSs or ordinary shares equal to the difference between the amount realized on the disposition and the U.S. holder’s tax basis in the ADSs or ordinary shares. This gain or loss will generally be long-term capital gain or loss if the U.S. holder has held the ADSs or ordinary shares for more than one year and otherwise will be short-term capital gain or loss. Long-term capital gains of individuals are eligible for preferential rates of taxation, which have been reduced for long-term capital gains recognized on or after May 6, 2003, and before January 1, 2011. Short-term capital gains are taxed at the rates applicable to ordinary income, which, for gains recognized on or after May 6, 2003, and before January 1, 2011, are higher than the rates applicable to dividends. For foreign tax credit limitation purposes, gain or loss recognized upon a disposition generally will be treated as from sources within the United States. The deductibility of capital losses is subject to limitations for U.S. federal income tax purposes.
     You should consult your tax advisor regarding the availability of a foreign tax credit or deduction in respect of any Australian tax imposed on a sale or other disposition of ADSs or ordinary shares. See “Australian Tax Considerations — Tax on Sales or other Dispositions of Shares.”
   Passive Foreign Investment Company Status
     The Code provides special anti-deferral rules regarding certain distributions received by U.S. stockholders with respect to, and sales and other dispositions, including pledges, of shares of stock of, a passive foreign investment company (“PFIC”). A foreign corporation will be treated as a PFIC for any taxable year if 75% or more of its gross income for the taxable year is passive income or the average percentage of its assets, generally by value, that produce or are held for the production of passive income is at least 50%.
     We believe that we were a PFIC for U.S. federal income tax purposes in 2000, 2002, 2003, 2004 and 2005, but not in 2001. We expect that Metal Storm will be a PFIC again in 2006 due to the asset test described above.
     As noted above, dividends received by an individual from a “qualified foreign corporation” are eligible for preferential rates of taxation. A qualified foreign corporation generally does not include any foreign corporation that is a PFIC for the taxable year in which the dividend is paid or for the preceding taxable year.
     A U.S. stockholder that holds stock in a foreign corporation during any taxable year in which the corporation qualifies as a PFIC is subject to tax under the “excess distribution” rules unless the stockholder elects to treat the PFIC as a “qualified electing fund” (“QEF”) or makes a “mark-to-market” election, each as discussed below. An “excess distribution” is a distribution with respect to PFIC stock that exceeds 125% of the average of such distributions over the preceding three-year period or, if shorter, the stockholder’s holding period for its shares. Excess distributions are allocated ratably to each day of the U.S. stockholder’s holding period. Amounts allocated to the current taxable year and any years before the corporation was a PFIC are currently included in gross income as ordinary income. Amounts allocated to other taxable years are taxed at the highest ordinary income tax rates in effect for those years, and the tax for each such prior year is subject to an interest charge at the rate applicable to income tax deficiencies. In addition, the entire amount of any gain that a U.S. stockholder realizes upon a sale or other disposition of shares in a PFIC is considered an excess distribution subject to tax and interest as described above. A U.S. stockholder that acquires shares in a PFIC from a decedent generally will not receive a “stepped-up” fair market value tax basis in such shares but, instead, will receive a tax basis equal to the decedent’s basis, if lower. If a corporation is a PFIC for any taxable year during which a U.S. stockholder holds shares in the corporation, then the corporation generally will continue to be treated as a PFIC with respect to the stockholder’s shares, even if the corporation no longer satisfies either the passive income or passive assets test described above, unless the U.S. stockholder terminates this deemed PFIC status by electing to recognize gain, which will be taxed under the excess distribution rules as if such shares had been sold on the last day of the last taxable year for which the corporation was a PFIC.
     The excess distribution rules may be avoided if a U.S. stockholder makes a QEF election effective beginning with the first taxable year in the stockholder’s holding period in which the corporation is a PFIC. A U.S. stockholder that makes a QEF election is required to include in income its pro rata share of the PFIC’s ordinary earnings and net capital gain as ordinary income and long-term capital gain, respectively, subject to a separate election to defer payment of taxes, which deferral is subject to an interest charge. A U.S. stockholder whose QEF election is effective after the first taxable year during the stockholder’s holding period in which the corporation is a PFIC (an “unpedigreed QEF election”) will continue to be subject to the excess distribution rules for years beginning with such first taxable year and prior to the year in which the QEF election first becomes effective, unless the stockholder elects to recognize as an excess distribution any gain that the stockholder would have recognized if the shares were sold on the first day of the first taxable year for which the QEF election is effective. Although an option to acquire PFIC stock generally is treated as PFIC stock for purposes of the excess distribution rules, a QEF election

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with respect to a stockholder’s shares will not apply to the stockholder’s options. If a stockholder that owns PFIC shares subject to a QEF election acquires additional shares pursuant to the exercise of an option, the additional shares will be subject to the QEF election, but the election may be an unpedigreed QEF election with respect to those shares.
     In general, a U.S. stockholder makes a QEF election by attaching a completed Internal Revenue Service (“IRS”) Form 8621 to a timely filed (taking into account extensions) U.S. federal income tax return for the year beginning with which the QEF election is to be effective. (A U.S. stockholder of a PFIC must file an IRS Form 8621 annually regardless of whether or not it makes a QEF election.) In certain circumstances, a U.S. stockholder may be able to make a retroactive QEF election. In order for a U.S. stockholder to make a valid QEF election, the corporation must annually provide or make available to the stockholder certain information. For any year that we are a PFIC, we will provide to U.S. holders the information necessary to report income and gain in accordance with a QEF election upon their written request to our Company Secretary. However, in the case of a U.S. holder that is a calendar year taxpayer, the information is not expected to be provided until after the due date for filing a U.S. federal income tax return without an extension. A QEF election can be revoked only with the consent of the IRS.
     As an alternative to making a QEF election, a U.S. stockholder may make a “mark-to-market” election with respect to its PFIC shares if the shares meet certain minimum trading requirements. A U.S. stockholder that makes a mark-to-market election will be required to include in income each year an amount equal to the excess of the fair market value of the shares that the stockholder owns as of the close of the taxable year over the stockholder’s adjusted tax basis in the shares. The U.S. stockholder will be entitled to a deduction for the excess, if any, of the stockholder’s adjusted tax basis in the shares over the fair market value of the shares as of the close of the taxable year; provided, however, that the deduction will be limited to the extent of any net mark-to-market gains with respect to the shares included by the U.S. stockholder under the election for prior taxable years. The U.S. stockholder’s basis in the shares will be adjusted to reflect the amounts included or deducted pursuant to the election. Amounts included in income pursuant to a mark-to-market election, as well as gain on the sale or exchange of the shares, will be treated as ordinary income. The deductible portion of any mark-to-market loss, as well as loss on a sale or exchange of shares to the extent that the amount of such loss does not exceed net mark-to-market gains previously included in income, will be treated as ordinary loss.
     The mark-to-market election applies to the taxable year for which the election is made and all subsequent taxable years, unless the shares cease to meet applicable trading requirements or the IRS consents to its revocation. The excess distribution rules generally do not apply to a U.S. stockholder for tax years for which a mark-to-market election is in effect. However, if a U.S. stockholder makes a mark-to-market election for PFIC stock after the beginning of the stockholder’s holding period for the stock, a coordination rule applies to ensure that the stockholder does not avoid the tax and interest charge with respect to amounts attributable to periods before the election.
     It is not clear whether our ADSs or ordinary shares will meet the minimum trading requirements necessary to permit a U.S. holder to make a mark-to-market election.
     U.S. holders are urged to consult their tax advisors as to the effect on them of the PFIC rules and the desirability of making, and the availability of, either a QEF election or a mark-to-market election with respect to our ADSs or ordinary shares. Metal Storm provides no advice on your taxation matters. The above should not be taken as advice by the reader of this document.
   Backup Withholding Tax and Information Reporting Requirements
     U.S. backup withholding tax and information reporting requirements generally apply to payments to non-corporate holders of ADSs or ordinary shares. Information reporting will apply to payments of dividends on, and to proceeds from the disposition of, ADSs or ordinary shares by a paying agent within the United States to a U.S. holder, other than an “exempt recipient,” including a corporation and certain other persons that, when required, demonstrate their exempt status. A paying agent within the United States will be required to withhold at the applicable statutory rate in respect of any payments of dividends on, and the proceeds from the disposition of, ADSs or ordinary shares within the United States to a U.S. holder, other than an “exempt recipient,” if the holder fails to furnish its correct taxpayer identification number or otherwise fails to comply with applicable backup withholding requirements.
     The discussion above is not intended to constitute a complete analysis of all tax considerations applicable to an investment in ADSs or ordinary shares. You should consult with your tax advisor concerning the tax consequences to you in your particular situation.
   Australian Tax Considerations
     In this section we discuss the material Australian tax considerations related to the acquisition, ownership and disposal by the absolute beneficial owners of ADSs which are evidenced by ADRs, or ordinary shares. This discussion is based upon existing Australian tax

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law as of the date of this annual report, which is subject to change, possibly retrospectively. This discussion does not address all aspects of Australian income tax law which may be important to particular investors in light of their individual investment circumstances, such as ADSs or shares held by investors subject to special tax rules (for example, financial institutions, insurance companies or tax exempt organizations). In addition, this summary does not discuss any foreign or state tax considerations, other than stamp duty. Prospective investors are urged to consult their tax advisors regarding the Australian and foreign income and other tax considerations of the purchase, ownership and disposition of the ADSs or shares. This summary is based upon the premise that the holder is not an Australian tax resident.
   Nature of ADRs for Australian Taxation Purposes
     ADSs held by a U.S. holder will be treated for Australian taxation purposes as held under a ‘bare trust’ for such holder. Consequently, the underlying ordinary shares will be regarded as owned by the ADS holder for Australian income tax and capital gains tax purposes. Dividends paid on the underlying ordinary shares will also be treated as dividends paid to the ADS holder, as the person beneficially entitled to those dividends. Therefore, in the following analysis we discuss the tax consequences to non-Australian resident holders of ordinary shares which, for Australian taxation purposes, will be the same as to U.S. holders of ADSs.
   Taxation of Dividends
     Australia operates a dividend imputation system under which dividends may be declared to be ‘franked’ to the extent of tax paid on company profits. Fully franked dividends are not subject to dividend withholding tax. Dividends payable by the company to non-Australian resident stockholders will be subject to dividend withholding tax, to the extent the dividends are unfranked. Dividend withholding tax will be imposed at 30%, unless a stockholder is a resident of a country with which Australia has a double taxation agreement. Under the provisions of the current Double Taxation Convention between Australia and the United States, the Australian tax withheld on unfranked dividends paid by us to which a resident of the United States is beneficially entitled is limited to 15%, unless the shares are effectively connected to a permanent establishment or fixed base in Australia through which the stockholder carries on business or provides independent personal services, respectively.
     If a company that is a non-Australian resident stockholder owns a 10% or more interest, the Australian tax withheld on dividends paid by us to which a resident of the United States is beneficially entitled is limited to 5%.
   Tax on Sales or other Dispositions of Shares—Capital gains tax
     Non-Australian resident stockholders will not be subject to Australian capital gains tax on the gain made on a sale or other disposal of our shares, unless they, together with associates, hold 10% or more of our issued capital at any time during the five years before the disposal of the shares. There are proposed changes to the current legislation, which would exempt holdings of 10% or more of issued capital from Australian capital gains tax. At the present time it is uncertain when these proposed changes might take effect.
     Currently, a non-Australian resident stockholder who owns a 10% or more interest would be subject to Australian capital gains tax to the same extent as Australian resident stockholders. The Australian Taxation Office maintains the view that Australian capital gains tax is not limited by the Double Taxation Convention between the United States and Australia. Australian capital gains tax applies to net capital gains at a taxpayer’s marginal tax rate but for certain stockholders a discount of the capital gain may apply if the shares have been held for 12 months or more. For individuals, this discount is 50%. Net capital gains are calculated after reduction for capital losses, which may only be offset against capital gains.
   Tax on Sales or other Dispositions of Shares—Stockholders Holding Shares on Revenue Account
     Some non-Australian resident stockholders may hold shares on revenue rather than on capital account, for example, share traders. These stockholders may have the gains made on the sale or other disposal of the shares included in their assessable income under the ordinary income provisions of the income tax law, if the gains are sourced in Australia.
     Non-Australian resident stockholders assessable under these ordinary income provisions in respect of gains made on shares held on revenue account would be assessed for such gains at the Australian tax rates for non-Australian residents, which start at a marginal rate of 29%. Some relief from Australian income tax may be available to such non-Australian resident stockholders under the Double Taxation Convention between the United States and Australia, for example, because the stockholder does not have a permanent establishment in Australia.
     To the extent an amount would be included in a non-Australian resident stockholder’s assessable income under both the capital gains tax provisions and the ordinary income provisions, the capital gain amount would generally be reduced, so that the stockholder would not be subject to double tax on any part of the income gain or capital gain.

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   Dual Residency
     If a stockholder were a resident of both Australia and the United States under those countries’ domestic taxation laws, that stockholder may be subject to tax as an Australian resident. If, however, the stockholder is determined to be a U.S. resident for the purposes of the Double Taxation Convention between the United States and Australia, the Australian tax would be subject to limitation by the Double Taxation Convention. Stockholders should obtain specialist taxation advice in these circumstances.
   Stamp Duty
     From July 1, 2001, any transfer of shares through trading on the Australian Stock Exchange, whether by Australian residents or foreign residents, are not subject to Queensland stamp duty.
   Australian Death Duty
     Australia does not have estate or death duties. No capital gains tax liability is realized upon the inheritance of a deceased person’s shares. The disposal of inherited shares by beneficiaries, may, however, give rise to a capital gains tax liability.
   Goods and Services Tax
     The issue or transfer of shares will not incur Australian goods and services tax and does not require a stockholder to register for Australian goods and services tax purposes.
F. Dividends and Paying Agents
     Not applicable.
G. Statements by Experts
     Not applicable.
H. Documents on Display
     We are subject to the periodic reporting and other informational requirements of the Exchange Act. Under the Exchange Act, we are required to file reports and other information with the SEC. Copies of reports and other information, when so filed, may be inspected without charge and may be obtained at prescribed rates at the public reference facilities maintained by the SEC at Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549. The public may obtain information regarding the Washington, D.C. Public Reference Room by calling the SEC at 1-800-SEC-0330. The public may also view our annual reports and other documents filed with the SEC on the internet at www.sec.gov. As a foreign private issuer, we are exempt from the rules under the Exchange Act prescribing the furnishing and content of quarterly reports and proxy statements, and our officers, directors and principal shareholders are exempt from the reporting and short-swing profit recovery provisions in Section 16 of the Exchange Act.

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Item 11. Quantitative and Qualitative Disclosure about Market Risk
     We invest excess cash in term deposits with high-quality financial institutions. We do not utilize derivative financial instruments, derivative commodity instruments, positions or transactions in any material manner. Accordingly, we believe that we are not subject to any material risks arising from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices or other market changes that affect market risk sensitive instruments. Since we do not invest in locations outside Australia, we are not subject to cross-border risks, with the exceptions of risk set out immediately below.
     We operate in Australia and the United States and, as a result, are subject to certain foreign currency exposure. Historically, currency translation gains and losses have been reflected as adjustments to stockholders’ equity, while transaction gains and losses have been reflected as components of income and loss. Translation gains and losses could be material depending upon changes in the exchange rate relationships between the Australian dollar and the U.S. dollar. See Item 5A “Operating and Financial Review and Prospects — Operating Results—Effects of Currency Fluctuations” above for a detailed description of the impact of foreign currency translation on our financial statements.
Item 12. Description of Securities Other than Equity Securities
     Not applicable.

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PART II
Item 13. Defaults, Dividend Arrearages and Delinquencies
     Not applicable.
Item 14. Material Modifications to the Rights of Security Holders and the Use of Proceeds
     Not applicable.
Item 15. Controls and Procedures
     Our management have evaluated the effectiveness of Metal Storm’s disclosure controls and procedures as of the end of the period covered by this report. Based on the evaluation, the principal executive officer and principal financial officer became aware of the weaknesses related to internal control over financial reporting as described below.
     In connection with their audits of our 2005 and 2004 consolidated financial statements, our independent auditors, Ernst & Young, advised our Audit Committee that they had identified a number of material weaknesses involving our systems and processes. Issues identified involved segregation of duties, incorrect application of accounting standards and processes surrounding preparation of the financial statements and related disclosures. Our auditors have concluded that the overall control environment has not been designed to achieve a remote likelihood that a material misstatement of the financial statements will not be prevented or detected.
     Our auditors noted that there had been improvements in the internal control environment during 2005, however, observations from the audit of the December 31, 2005 consolidated financial statements indicate that these weaknesses still exist in Metal Storm’s internal control environment.
     U.S. GAAP Knowledge
     Our auditors have noted that the design and operation of our process for financial reporting in accordance with U.S. GAAP continues to be inadequate.
     In order to improve our knowledge of U.S. GAAP, our senior finance staff are committed to attending targeted U.S. GAAP and SEC reporting courses and to subscribing to additional information publications and updates of SEC and U.S. GAAP releases, rule changes and information related to internal controls in accordance with standards established by the Public Company Accounting Oversight Board, to the extent that such standards are applicable to us. We will also continue to improve our controls and processes around reporting under U.S. GAAP including the hiring outside accounting advisors with respect to the technical requirements applicable to our financial statements.
     Segregation of Duties
     Our auditors noted that the lack of adequate segregation of duties is a common problem for companies the size of Metal Storm and recommended various measures to establish such controls.
     We have taken measures to establish internal controls during 2005 over the financial reporting related to the segregation of duties by implementing the recommendations of our auditors. We employed a new Chief Financial Officer in October 2004 who independently reviews the processes performed by an experienced financial controller who was recruited by us in June 2005. We believe that the segregation of duties between the financial controller and the Chief Financial Officer, the periodic review by the Chief Financial Officer of the processes performed by the financial controller, and the introduction of the other measures recommended by our auditors will improve our internal controls over financial reporting.
     Financial Statement Close Process
     Our auditors noted that although we have undertaken certain corrective measures, substantial improvement is needed in our financial statement close process as evidenced by the number and dollar value of audit adjustments identified and corrected during the 2005 audit, the failure to reconcile certain accounts on a timely basis, the ability to override entries in the accounting system without leaving appropriate documentation, and lack of supporting documentation for certain provisions and reserves and corrected has disappeared.
     Following the recommendations of our auditors, we are engaging another accounting firm to provide advice and support where necessary to address these noted deficiencies as well as help ensure that future transactions and related accounts are identified and recorded on a timely and accurate basis and that sufficient supporting documentation is prepared on a timely basis.
     Management is actively continuing in the execution of their plans to implement the appropriate processes and procedures to address these noted weaknesses. Our Audit Committee is taking an active role in this process and is monitoring the progress of these changes.

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Item 16A. Audit Committee Financial Expert
     James M. Crunk is an “audit committee financial expert” (as defined in Item 16A of Form 20-F) and is “independent” (as defined in the rules of The Nasdaq Stock Market). Please see Item 6A “Directors, Senior Management and Employees — Directors and Senior Management” for details of his background.
Item 16B. Code of Ethics
     We have adopted a code of conduct to guide executives, management and employees in carrying out their duties and responsibilities. The code of conduct covers such matters as:
    responsibilities to shareholders;
 
    compliance with laws and regulations;
 
    relations with customers and suppliers;
 
    ethical responsibilities;
 
    employment practices; and
 
    responsibilities to the environment and the community.
     We undertake to provide to any person without charge, upon request, a copy of our code of conduct. Please contact our Company Secretary at 011-61-7-3221-9733 to obtain a copy.
     In 2005, we did not (expressly or implicitly) grant a waiver under our code of conduct to our principal executive officer, our principal accounting officer or controller or persons performing similar functions.
Item 16C. Principal Accountant Fees and Services
                 
    December 31,
    2005   2004
    A$   A$
Audit Fees
    385,410       437,661  
 
               
Audit-Related Fees
    31,500        
 
               
Tax Fees
           
 
               
All Other Fees
          6,279  
 
               
Total
    416,910       443,940  
 
               
     Fees for audit services include fees associated with the annual audit of the consolidated financial statements, including the reconciliation to U.S. GAAP and reviews of Metal Storm's half-year reports. Audit-related fees principally include the performance of agreed-upon procedures in connection with capital raising activities and accounting consultation. Tax fees include tax compliance services. All other fees include reading press releases.
     The audit committee pre-approved the engagement of Ernst & Young for all the services described in Item 16C.
Item 16D. Exemptions from the Listing Standards for Audit Committees.
     Not applicable.

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Item 16E. Purchases of Equity Securities by the Issuer and Affiliated Purchasers
     Not applicable.

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PART III
Item 17. Financial Statements
     The financial statements are included as the “F” pages to this annual report.
Item 18. Financial Statements
     Not applicable.
Item 19. Exhibits
     
Exhibit    
Number   Description of Exhibit
1.1
  Constitution of Metal Storm*
 
   
4.1
  DSTO Research Agreement dated April 20, 2001*
 
   
4.2
  Deed of Amendment to the DSTO Research Agreement dated September 13, 2002 (portions omitted pursuant to a request for confidential treatment; non-public information has been filed with the SEC)**
 
   
4.3
  DSTO Technology License Agreement dated April 20, 2001, as amended (portions omitted pursuant to a request for confidential treatment; non-public information has been filed with the SEC)*
 
   
4.4
  Asset Purchase Agreement, dated May 24, 2005, with Monroe Machined Products, Inc. (“MMP”) for the sale of the ProCam business to MMP.****
 
   
4.5
  Employment Agreement of David A. Smith****
 
   
4.6
  Separation Agreement, dated February 8, 2005, of J.M. O’Dwyer****
 
   
4.7
  Deed of Termination Agreement, dated May 20, 2006, of David A. Smith
 
   
4.8
  Employment Agreement of James D. MacDonald****
 
   
4.9
  Employment Agreement of George L. Bergeron***
 
   
4.10
  Cash Advance Facility Agreement, dated June 16, 2006, between Metal Storm and Harmony Investment Fund Limited
 
   
4.11
  Discretionary Share Option Scheme*
 
   
4.12
  Employment Agreement of Ian A. Gillespie***
 
   
8.0
  List of Subsidiaries of Metal Storm Limited
 
   
12.1
  Certification by the Executive Chairman of Metal Storm Limited in accordance with Section 302 of the Sarbanes-Oxley Act
 
   
12.2
  Certification by the Chief Financial Officer of Metal Storm Limited in accordance with Section 302 of the Sarbanes-Oxley Act
 
   
13.1
  Certification by the Executive Chairman in accordance with Section 906 of the Sarbanes-Oxley Act
 
   
13.2
  Certification by the Chief Financial Officer in accordance with Section 906 of the Sarbanes-Oxley Act
 
*   Incorporated by reference from our Registration Statement on Form 20-F filed on December 12, 2001, File No. 000-31212.
 
**   Incorporated by reference from our Annual Report on Form 20-F filed on July 14, 2003.
 
***   Incorporated by reference from our Annual Report on Form 20-F filed on July 15, 2004.
 
****   Incorporated by reference from our Annual Report on Form 20-F filed on June 15, 2005.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of Metal Storm Limited
We have audited the accompanying consolidated balance sheets of Metal Storm Limited as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Metal Storm Limited at December 31, 2005 and 2004, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with Australian equivalents to International Financial Reporting Standards, which differ in certain respects from accounting principles generally accepted in the United States of America (see notes 30 and 31 to the consolidated financial statements).
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As more fully described in Note 1, the Company has incurred recurring operating losses and negative cash flows from operating activities. To fund the expected levels of operating expenditures, the Company will require additional sources of capital. While the Company has previously been successful in raising additional capital, there can be no assurance that it will be able to raise sufficient capital to continue its operations. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters also are described in Note 1. The Company’s consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.
/s/ Ernst & Young
Brisbane, Australia
July 11, 2006

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Metal Storm Limited
Consolidated Income Statement (Australian Dollars)
For the Years Ended 31 December 2005 and 2004
                         
            2005   2004
    Note   A$   A$
             
Continuing operations
                       
 
                       
Revenue
    5       830,645       837,201  
 
                       
Expenses
                       
Consumables used
            (4,360 )      
Employee expenses
    5       (4,468,640 )     (3,751,459 )
Professional fees
            (1,774,369 )     (2,021,573 )
Research and development
            (1,794,684 )     (1,613,365 )
Administrative expenditure
            (928,931 )     (1,326,897 )
Facilities and equipment
            (522,693 )     (419,114 )
Travel and entertainment
            (433,859 )     (796,611 )
Communication and technology
            (306,335 )     (342,549 )
Public relations and compliance
            (494,786 )     (617,710 )
Unrealised net foreign exchange differences
    5       (785 )     1,378  
Realised net foreign exchange differences
    5       (26,237 )     7,307  
Impairment loss on goodwill
    5,17             (1,834,152 )
Finance costs
    5       (35,496 )     (43,568 )
 
                       
             
Loss before income tax
            (9,960,530 )     (11,921,112 )
 
                       
Income tax benefit
    6       648,320       332,744  
 
                       
             
Loss after tax from continuing operations
            (9,312,210 )     (11,588,368 )
 
                       
Discontinued operation
                       
 
                       
Loss after tax from discontinued operation
    7       (1,602,390 )     (1,515,759 )
 
                       
             
Loss attributable to members of the parent
    8       (10,914,600 )     (13,104,127 )
             
 
                       
Earnings per share (cents per share)
                       
— Basic and diluted loss for the year attributable to ordinary equity holders of the parent
    8       (2.09 )     (2.62 )
— Basic and diluted loss for the year from continuing operations attributable to ordinary equity holders of the parent
    8       (1.78 )     (2.31 )
Dividends per share
                   

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Metal Storm Limited
Consolidated Balance Sheet (Australian Dollars)
As at 31 December 2005 and 2004
                         
            2005   2004
    Note   A$   A$
             
Assets
                       
Current assets
                       
Cash and cash equivalents
    9       635,861       15,109,596  
Available-for-sale financial investments
    10       5,056,140        
Trade and other receivables
    11       635,209       590,188  
Inventories
    12             250,982  
Prepayments
            810,112       553,759  
Other financial assets
    13             845,446  
             
Total current assets
            7,137,322       17,349,971  
             
 
                       
Non-current assets
                       
Trade and other receivables
    11       8,832       3,397  
Property, plant and equipment
    15       231,629       2,947,804  
Intangible assets and goodwill
    16       51,938       26,145  
             
Total non-current assets
            292,399       2,977,346  
             
 
                       
Total assets
            7,429,721       20,327,317  
             
 
                       
Liabilities
                       
Current liabilities
                       
Trade and other payables
    19       890,550       1,696,033  
Interest-bearing loans and borrowings
    20       353,674       1,478,836  
Provisions
    21       277,448       332,496  
Other
            43,024        
             
Total current liabilities
            1,564,696       3,507,365  
             
 
                       
Non-current liabilities
                       
Interest-bearing loans and borrowings
    20             578,160  
Provisions
    21             41,403  
Other
            85,163       396  
             
Total non-current liabilities
            85,163       619,959  
             
 
                       
Total liabilities
            1,649,859       4,127,324  
             
Net assets
            5,779,862       16,199,993  
             
 
                       
Equity
                       
Contributed equity
    22       56,559,039       56,559,039  
Share-based payment reserves
    22       1,726,182       1,316,454  
Other reserves
    22       (58,125 )     (142,866 )
Retained losses
    22       (52,447,234 )     (41,532,634 )
             
Total equity
            5,779,862       16,199,993  
             

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Metal Storm Limited
Consolidated Statement of Cash Flows (Australian Dollars)
For the Years Ended 31 December 2005 and 2004
                         
            2005   2004
    Note   A$   A$
             
Cash Flows From Operating Activities
                       
Receipts from customers
            1,299,567       5,396,079  
Contract revenue funding received
            188,794       42,610  
Payments to suppliers and employees
            (13,205,669 )     (17,006,485 )
Interest and other costs of finance paid
            (96,157 )     (295,435 )
Income tax refund – research & development
            310,755       332,744  
Other – GST received
            261,451       293,832  
             
Net cash flows used in operating activities
    9       (11,241,259 )     (11,236,655 )
             
 
                       
Cash Flows From Investing Activities
                       
Purchase of property, plant and equipment
            (104,292 )     (257,325 )
Proceeds from the disposal of discontinued operation
    7       2,256,721        
Purchase of intangible assets
            (74,007 )     (19,030 )
Interest received
            613,030       810,302  
Purchase of available-for-sale financial assets
            (8,633,480 )      
Proceeds from sale of available-for-sale financial assets
            3,614,000        
Purchase of other financial asset
    13             (845,446 )
Proceeds from other financial asset
    13       857,536        
             
Net cash flows used in investing activities
            (1,470,492 )     (311,499 )
             
 
                       
Cash Flows From Financing Activities
                       
Proceeds from issues of equity securities
                  21,511,418  
Share issue costs
                  (1,705,107 )
Proceeds from exercise of options
                  3,007  
Proceeds from borrowings
            706,698       1,113,146  
Repayment of borrowings
            (2,466,723 )     (2,319,393 )
             
Net cash flows (used in)/from financing activities
            (1,760,025 )     18,603,071  
             
 
                       
Net movement in cash and cash equivalents
            (14,471,776 )     7,054,917  
Net foreign exchange differences
            (1,959 )      
Cash and cash equivalents at beginning of period
            15,109,596       8,054,679  
             
Cash and cash equivalents at end of period
    9       635,861       15,109,596  
             
Supplementary Information of Non-Cash Investing and Financing Activities
During 2005, the Company acquired no assets by way of capital lease (2004: $61,014).

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Metal Storm Limited
Consolidated Statement of Changes in Equity (Australian Dollars)
For the Years Ended 31 December 2005 and 2004
                                         
            Share-            
            based            
    Issued   payment   Other   Retained   Total
    capital   reserves   reserves   losses   equity
    A$   A$   A$   A$   A$
     
At 1 January 2004
    36,638,128       515,009       (22,883 )     (28,428,507 )     8,701,747  
Currency translation differences
                (119,983 )           (119,983 )
Share issue costs
    (1,705,107 )                       (1,705,107 )
     
Total income and expense for the year recognised directly in equity
    (1,705,107 )           (119,983 )           (1,825,090 )
Loss for the year
                      (13,104,127 )     (13,104,127 )
     
Total income/expense for the year
    (1,705,107 )           (119,983 )     (13,104,127 )     (14,929,217 )
     
Exercise of options
    3,007                         3,007  
Net increase in share-based payment reserves
          801,445                   801,445  
Issue of share capital
    21,511,418                         21,511,418  
Fair value of services paid for via issue of shares
    111,593                         111,593  
     
At 31 December 2004
    56,559,039       1,316,454       (142,866 )     (41,532,634 )     16,199,993  
     
 
                                       
Net gains on available-for-sale financial assets
                36,660             36,660  
Currency translation differences
                48,081             48,081  
     
Total income and expense for the year recognised directly in equity
                84,741             84,741  
Loss for the year
                      (10,914,600 )     (10,914,600 )
     
Total income/expense for the year
                84,741       (10,914,600 )     (10,829,859 )
     
Net increase in share-based payment reserves
          409,728                   409,728  
     
At 31 December 2005
    56,559,039       1,726,182       (58,125 )     (52,447,234 )     5,779,862  
     

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Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars)
For the Years Ended 31 December 2005 and 2004
1. Going Concern
The consolidated financial statements have been prepared on the basis of going concern which contemplates continuity of normal business activities and the realisation of assets and settlement of liabilities in the ordinary course of business.
Key financial data for the Company for the financial years 2005 and 2004 is disclosed below:
                 
    2005   2004
    A$   A$
     
Loss attributable to members of the parent
    (10,914,600 )     (13,104,127 )
Cumulative losses from inception
    (52,447,234 )     (41,532,634 )
Net cash flows used in operating activities
    (11,241,259 )     (11,236,655 )
Cash including available-for-sale financial investments
    5,692,001       15,109,596  
Working capital
    5,572,626       13,842,606  
Shareholders’ equity
    5,779,862       16,199,993  
In order to meet the Company’s objectives to develop, manufacture and market commercial products effectively, the Company will require additional funding until such time that product sales are of sufficient volume to generate positive cash flows from operations. This has taken longer and has cost more than originally anticipated. Based on the expected levels of operating expenditures, in order to continue its operations, the Company will require additional sources of capital. Possible sources of funds are additional collaborative and research and development arrangements, strategic alliances, additional equity offerings, debt offerings and additional grants. While the Company has previously been successful in raising additional capital, there can be no assurance that it will be able to raise sufficient capital to continue its operations. If the Company is unsuccessful in its efforts to obtain sufficient financing to continue to fund its current operations, the Company will be required to significantly reduce or cease operations altogether. Accordingly, there exists a substantial doubt about the Company’s ability to continue as a going concern.
The Directors believe that the Company will succeed in securing additional funding in the near future. The Company has previously relied on the support of their shareholders and the investment community to provide equity funding to support their activities. The Directors are actively seeking further funding to allow the Company to continue to operate. In the Directors’ opinion, there are reasonable grounds to believe that such funding will continue to be available.
However, if such funding is unavailable, there is significant uncertainty as to whether the Company will continue as a going concern and, therefore may realise its assets and settle its liabilities at amounts different from those stated in the consolidated financial statements. As announced at the Company’s Annual General Meeting on April 28, 2006 an aggressive cost cutting program has been introduced which is expected to produce significant cost savings. Further cost saving strategies will be introduced if additional funding is not available.
In May 2006, the Company raised A$2.7 million, net of transaction costs, through a share purchase plan available only to shareholders resident in Australia and New Zealand. Refer to Note 27 for further information regarding capital raising activity subsequent to year end.
No adjustments have been made to the financial statements relating to the recoverability and classification of the asset carrying amounts or classification of liabilities that might be necessary should the Company not continue as a going concern.

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Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
2. Corporate Information
The accompanying consolidated financial statements of Metal Storm Limited for the year ended 31 December 2005 were originally authorised for issue in Australia in accordance with a resolution of the Directors on 16 March 2006.
Metal Storm Limited is a company limited by shares incorporated in Australia whose shares are publicly traded on the Australian Stock Exchange (trading code: MST) with American Depository Receipts (ADR’s) traded on the NASDAQ exchange in the United States of America (ticker symbol: MSTX).
The nature of the operations and principal activities of Metal Storm Limited are described in Note 4.

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Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
3. Summary of Significant Accounting Policies
(a) Basis of Preparation
The consolidated financial statements are general purpose financial statements, which have been prepared in accordance with Australian Accounting Standards, which include Australian equivalents to International Financial Reporting Standards (“AIFRS”). The consolidated financial statements have also been prepared on a historical cost basis, except for available-for-sale financial assets that have been measured at fair value.
The consolidated financial statements are presented in Australian dollars.
(b) Statement of Compliance
The consolidated financial statements comply with Australian Accounting Standards, including AIFRS, which as applied by the Company also complies with International Financial Reporting Standards (‘IFRS’).
This is the first set of consolidated financial statements prepared based on AIFRS and comparatives for the year ended 31 December 2004 have been restated accordingly except for the adoption of AASB 132 (IAS 32) Financial Instruments: Disclosure and Presentation and AASB 139 (IAS 39) Financial Instruments: Recognition and Measurement. The Company has adopted the exemption under AASB 1 First-time Adoption of Australian Equivalents to International Financial Reporting Standards from having to apply AASB 132 (IAS 32) and AASB 139 (IAS 39) to the comparative period.
Australian Accounting Standards that have recently been issued or amended but are not yet effective have not been adopted for the annual reporting period ending 31 December 2005:
                 
            Application    
AASB       Nature of change to   date of   Application date
Amendment   Affected Standard(s)   accounting policy   Standard*   for Company
2005-1
  AASB 139: Financial Instrument: Recognition and measurement (IAS 39)   No change to accounting policy required. Therefore no impact.   1 January 2006   1 January 2006
 
               
2005-5
  AASB 1: First-time adoption of AIFRS (IFRS 1), AASB 139: Financial Instrument: Recognition and measurement (IAS 39)   No change to accounting policy required. Therefore no impact.   1 January 2006   1 January 2006
 
               
2005-6
  AASB 3: Business Combinations (IAS 3)   No change to accounting policy required. Therefore no impact.   1 January 2006   1 January 2006
 
               
2005-10
  AASB 132: Financial Instruments: Disclosure and Presentation (IAS 32), AASB 101: Presentation of Financial Statements (IAS 1),AASB 114:   No change to accounting policy required. Therefore no impact.   1 January 2007   1 January 2007
 
  Segment Reporting (IAS 14), AASB 117: Leases (IAS 17), AASB 113: Earnings per Share (IAS 33), AASB 139: Financial Instrument: Recognition and measurement (IAS 39), AASB 1: First-time adoption of AIFRS (IFRS 1)            
 
               
2006-1
  AASB 121: The Effects of Changes in Foreign Exchange Rates (IAS 21)   No change to accounting policy required. Therefore no impact.   1 January 2006   1 January 2006
 
               
New Standard
  AASB 7: Financial Instruments:
Disclosures
(IFRS 7)
  No change to accounting policy required. Therefore no impact.   1 January 2007   1 January 2007
 
*   Application date is for the annual reporting periods beginning on or after the date shown in the above table.

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Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
3. Summary of Significant Accounting Policies (continued)
(b) Statement of Compliance (continued)
The following amendments are not applicable to the Company and therefore have no impact.
     
AASB   Affected
Amendment   Standard(s)
2005-2
  AASB 1023 General Insurance Contracts
 
   
2005-4
  AASB 139 Financial Instruments: Recognition and Measurement (IAS 39), AASB 132 Financial Instruments: Disclosure and Presentation (IAS 32), AASB 1 First-time adoption of AIFRS (IFRS 1), AASB 1023 General Insurance Contracts and AASB 1028 Life Insurance Contracts
 
   
2005-9
  AASB 4 Insurance Contracts (IAS 4), AASB 1023 General Insurance Contracts, AASB 139 Financial Instruments: Recognition and Measurement and AASB 132 Financial Instruments: Disclosure and Presentation (IAS 32)
 
   
2005-12
  AASB 1038 Life Insurance Contracts and AASB 1023 General Insurance Contracts
 
   
2005-13
  AAS 25 Financial Reporting by Superannuation Plans
(c) Basis of Consolidation
The consolidated financial statements comprise the financial statements of Metal Storm Limited (‘the Company’) and its subsidiaries as at 31 December each year.
The financial statements of subsidiaries are prepared for the same reporting period as the parent company, using consistent accounting policies.
In preparing the consolidated financial statements all intercompany balances and transactions, income and expenses and profits and losses resulting from intra-company transactions have been eliminated in full.
Subsidiaries are fully consolidated from the date on which control is transferred to the Company and cease to be consolidated from the date on which control is transferred out of the Company.
(d) Significant Accounting Judgements, Estimates and Assumptions
Significant accounting estimates and assumptions
The carrying amounts of certain assets and liabilities are often determined based on estimates and assumptions of future events. The key estimates and assumptions that have a significant risk of causing a material adjustment to the carrying amounts of certain assets and liabilities within the next annual reporting period are:
Impairment of goodwill and intangibles with indefinite useful lives
The Company determines whether goodwill and intangibles with indefinite useful lives are impaired at least on an annual basis. This requires an estimation of the recoverable amount of the cash generating units to which the goodwill and intangibles with indefinite useful lives are allocated.
The assumptions used in this estimation of recoverable amount and the carrying amount of goodwill and intangibles with indefinite useful lives are discussed in Note 17.
Share-based payment transactions
The Company measures the cost of equity-settled transactions with employees by reference to the fair value of the equity instruments at the date at which they are granted. The fair value is determined using a Black-Scholes model, using the assumptions detailed in Note 18.

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
3. Summary of Significant Accounting Policies (continued)
(e) Foreign Currency Translation
The functional currency of Metal Storm Limited (the parent), Metal Storm Inc. and Metal Storm USA is Australian dollars. The presentation currency of Metal Storm Limited is Australian dollars.
Transactions in foreign currencies are initially recorded in the functional currency at the exchange rates ruling at the date of the transaction. Monetary assets and liabilities denominated in foreign currencies are retranslated at the rate of exchange ruling at the balance sheet date.
All differences in the consolidated financial statements are taken to the Income Statement.
The functional currency of ProCam Machine LLC is United States dollars.
As at the reporting date the assets and liabilities of ProCam Machine LLC are translated into the presentation currency of Metal Storm Limited at the closing exchange rate for the reporting period. The income statements are translated at the weighted average exchange rates for the period.
The exchange differences arising on translation are recognised as a separate component of equity.
On disposal of the subsidiary, or part thereof, the deferred cumulative amount recognised in equity is recognised in the Income Statement.
(f) Property, Plant and Equipment
Plant and equipment is stated at cost less accumulated depreciation and any accumulated impairment losses.
Depreciation is calculated on a straight-line basis over the estimated useful life of the asset as follows:
Leased plant and equipment – over the lease term which ranges from 1 to 5 years
Plant and equipment – over 2.5 to 5 years
Derecognition and disposal
The assets’ residual values, useful lives and amortisation methods are reviewed and adjusted if appropriate at each financial year end.
An item of property, plant and equipment is derecognised upon disposal or when no future economic benefits are expected from its use of disposal.
Any gain or loss arising on derecognition of the asset (calculated as the difference between the net disposal proceeds and the carrying amount of the asset) is included in the Income Statement in the period the asset is derecognised.
Impairment
The carrying values of plant and equipment are reviewed for impairment at each reporting date with recoverable amount being estimated when events or changes in circumstances indicate the carrying value may be impaired.
The recoverable amount of plant and equipment is the greater of fair value less costs to sell and value in use. In assessing value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset.
For an asset that does not generate largely independent cash inflows, the recoverable amount is determined for the cash-generating unit to which the asset belongs, unless the asset’s value in use can be estimated to be close to fair value.

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
3. Summary of Significant Accounting Policies (continued)
(f) Property, Plant and Equipment (continued)
Impairment (continued)
An impairment exists when the carrying value of an asset or cash generating unit exceeds its estimated recoverable amount. The asset or cash generating unit is then written down to its recoverable amount.
Impairment losses are recognised in the Income Statement in the facilities and equipment line item.
(g) Borrowing Costs
Borrowing costs are recognised as an expense when incurred.
(h) Goodwill
Goodwill acquired in a business combination is initially measured at cost being the excess of the cost of the business combination over the Company’s interest in the net fair value of the acquiree’s identifiable assets, liabilities and contingent liabilities.
Following initial recognition, goodwill is measured at cost less any accumulated impairment losses.
Goodwill is reviewed for impairment annually or more frequently if events or changes in circumstances indicate that the carrying value may be impaired.
As at the acquisition date, any goodwill acquired is allocated to each of the cash-generating units expected to benefit from the combination’s synergies.
Impairment is determined by assessing the recoverable amount of the cash-generating unit to which the goodwill relates. When the recoverable amount of the cash-generating unit is less than the carrying amount, an impairment loss is recognised. When goodwill forms part of a cash-generating unit and an operation within that unit is disposed of, the goodwill associated with the operation disposed of is Included in the carrying amount of the operation when determining the gain or loss on disposal of the operation. Goodwill disposed of in this circumstance is measured on the basis of the relative values of the operation disposed of and the portion of the cash-generating unit retained.
Impairment losses recognised for goodwill are not subsequently reversed.
(i) Intangible Assets
Acquired both separately and from a business combination
Intangible assets acquired separately are capitalised at cost and from a business combination are capitalised at fair value as at the date of acquisition. Following initial recognition, intangible assets are carried at cost less any accumulated amortisation and accumulated impairment losses. Internally generated intangible assets, excluding development costs, are not capitalised and expenditure is charged against profits in the year in which the expenditure is incurred.
The useful lives of these intangible assets are assessed to be either finite or indefinite. Intangible assets with finite lives are amortised over the useful life and assessed for impairment whenever there is an indication that the intangible asset may be impaired. The amortisation period and the amortisation method for an intangible asset with a finite useful life is reviewed at least at each financial year-end. Changes in the expected useful life or the expected pattern of consumption of future economic benefits embodied in the asset are accounted for by changing the amortisation period or method, as appropriate, which is a change in accounting estimate. The amortisation expense on intangible assets with finite lives is recognised in profit or loss in the expense category consistent with the function of the intangible asset.
Intangible assets with indefinite useful lives are tested for impairment annually either individually or at the cash-generating unit level. Such intangibles are not amortised. The useful life of an intangible asset with an indefinite life is reviewed each reporting period to

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
3. Summary of Significant Accounting Policies (continued)
(i) Intangible Assets (continued)
determine whether indefinite life assessment continues to be supportable. If not, the change in the useful life assessment from indefinite to finite is accounted for as a change in an accounting estimate and is thus accounted for on a prospective basis.
Research and development costs
Research costs are expensed as incurred. An intangible asset arising from development expenditure on an internal project is recognised only when the Company can demonstrate the technical feasibility of completing the intangible asset so that it will be available for use or sale, its intention to complete and its ability to use or sell the asset, how the asset will generate future economic benefits, the availability of resources to complete the development and the ability to measure reliably the expenditure attributable to the intangible asset during its development. Following the initial recognition of the development expenditure, the cost model is applied requiring the asset to be carried at cost less any accumulated amortisation and accumulated impairment losses. Any expenditure so capitalised is amortised over the period of expected benefits from the related project.
The carrying value of an intangible asset arising from development expenditure is tested for impairment annually when the asset is not yet available for use, or more frequently when an indication of impairment arises during the reporting period.
A summary of the policies applied to the Company’s intangible assets is as follows:
     
Policy   Software
Useful life
  Finite
Amortisation method used
  Depreciated over useful life
Internally generated or acquired
  Acquired
Impairment testing
  Annually where an indicator of impairment exists
Gains or losses arising from derecognition of an intangible asset are measured as the difference between the net disposal proceeds and the carrying amount of the asset and are recognised in the Income Statement when the asset is derecognised.
(j) Impairment of assets
The Company assesses at each reporting date whether there is an indication that an asset may be impaired. If any such indication exists, or when annual impairment testing for an asset is required, the Company makes an estimate of the asset’s recoverable amount. An asset’s recoverable amount is the higher of its fair value less costs to sell and its value in use and is determined for an individual asset, unless the asset does not generate cash inflows that are largely independent of those from other assets or groups of assets and the asset’s value in use cannot be estimated to be close to its fair value. In such cases the asset is tested for impairment as part of the cash-generating unit to which it belongs. When the carrying amount of an asset or cash-generating unit exceeds its recoverable amount, the asset or cash-generating unit is considered impaired and is written down to its recoverable amount.
In assessing value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset. Impairment losses relating to continuing operations are recognised in those expense categories consistent with the nature of the impaired asset unless the asset is carried at revalued amount (in which case the impairment loss is treated as a revaluation decrease).
An assessment is also made at each reporting date as to whether there is any indication that previously recognised impairment losses may no longer exist or may have decreased. If such indication exists, the recoverable amount is estimated. A previously recognised impairment loss is reversed only if there has been a change in the estimates used to determine the asset’s recoverable amount since the last impairment

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
3. Summary of Significant Accounting Policies (continued)
(j) Impairment of assets (continued)
loss was recognised. If that is the case the carrying amount of the asset is increased to its recoverable amount. That increased amount cannot exceed the carrying amount that would have been determined, net of depreciation, had no impairment loss been recognised for the asset in prior years. Such reversal is recognised in profit or loss unless the asset is carried at revalued amount, in which case the reversal is treated as a revaluation increase. After such a reversal the depreciation charge is adjusted in future periods to allocate the asset’s revised carrying amount, less any residual value, on a systematic basis over its remaining useful life.
(k) Investments and Other Financial Assets
The Company has elected to apply the option available under AASB 1 of adopting AASB 132 and AASB 139 from 1 July 2005. Outlined below are the relevant accounting policies for investments and other financial assets applicable for the years ending 31 December 2005 and 31 December 2004.
Accounting policies applicable for the year ending 31 December 2005
Financial assets in the scope of AASB 139 Financial Instruments: Recognition and Measurement are classified as either financial assets at fair value through profit or loss, loans and receivables, held-to-maturity investments, or available-for-sale investments, as appropriate. When financial assets are recognised initially, they are measured at fair value, plus, in the case of investments not at fair value through profit or loss, directly attributable transactions costs. The Company determines the classification of its financial assets after initial recognition and, when allowed and appropriate, re-evaluates this designation at each financial year-end.
(i) Financial assets at fair value through profit or loss
Financial assets classified as held for trading are included in the category ‘financial assets at fair value through profit or loss’. Financial assets are classified as held for trading if they are acquired for the purpose of selling in the near term. Derivatives are also classified as held for trading unless they are designated as effective hedging instruments. Gains or losses on investments held for trading are recognised in profit or loss.
(ii) Held-to-maturity investments
Non-derivative financial assets with fixed or determinable payments and fixed maturity are classified as held-to-maturity when the Company has the positive intention and ability to hold to maturity. Investments intended to be held for an undefined period are not included in this classification. Investments that are intended to be held-to-maturity, such as bonds, are subsequently measured at amortised cost. This cost is computed as the amount initially recognised minus principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between the initially recognised amount and the maturity amount. This calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate, transaction costs and all other premiums and discounts. For investments carried at amortised cost, gains and losses are recognised in profit or loss when the investments are derecognised or impaired, as well as through the amortisation process.
(iii) Available-for-sale investments
Available-for-sale investments are those non-derivative financial assets that are designated as available-for-sale or are not classified as any of the preceding categories. After initial recognition available-for sale investments are measured at fair value with gains or losses being recognised as a separate component of equity until the investment is derecognised or until the investment is determined to be impaired, at which time the cumulative gain or loss previously reported in equity is recognised in profit or loss.

F-14


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
3. Summary of Significant Accounting Policies (continued)
(l) Inventories
Inventories are valued at the lower of cost and net realisable value.
Costs incurred in bringing each product to its present location and condition are accounted for as follows: Raw materials – purchase cost on a first-in, first-out basis;
Finished goods and work-in-progress – cost of direct materials and labour and a proportion of manufacturing overheads based on normal operating capacity but excluding borrowing costs.
Net realisable value is the estimated selling price in the ordinary course of business, less estimated costs of completion and the estimated costs necessary to make the sale.
(m) Trade and Other Receivables
The Company has elected to apply the option available under AASB 1 of adopting AASB 132 and AASB 139 from 1 July 2005. Outlined below are the relevant accounting policies for trade and other receivables applicable for the years ending 31 December 2005 and 31 December 2004. There was no impact to the consolidated financial statements as a result of this change.
Accounting policies applicable for the year ending 31 December 2005
Trade receivables, which generally have 30-90 day terms, are recognised and carried at original invoice amount less an allowance for any uncollectible amounts.
An allowance for doubtful debts is made when there is objective evidence that the Company will not be able to collect the debts. Bad debts are written off when identified.
Accounting policies applicable for the year ending 31 December 2004
Trade receivables were recognised and carried at original invoice amount less a provision for any uncollectible debts. An estimate for doubtful debts was made when collection of the full amount was no longer probable. Bad debts were written off as incurred.
(n) Cash and Cash Equivalents
Cash and short-term deposits in the balance sheet comprise cash at bank and in hand and short-term deposits with an original maturity of three months or less.
For the purposes of the Cash Flow Statement, cash and cash equivalents consist of cash and cash equivalents as defined above, net of outstanding bank overdrafts.
(o) Interest-bearing Loans and Borrowings
The Company has elected to apply the option available under AASB 1 of adopting AASB 132 and AASB 139 from 1 July 2005. Outlined below are the relevant accounting policies for interest-bearing loans and borrowings applicable for the years ending 31 December 2005 and 31 December 2004. There was no impact to the consolidated financial statements as a result of this change.
Accounting policies applicable for the year ending 31 December 2005
All loans and borrowings are initially recognised at the fair value of the consideration received less directly attributable transaction costs.
After initial recognition, interest-bearing loans and borrowings are subsequently measured at amortised cost using the effective interest method.

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
3. Summary of Significant Accounting Policies (continued)
(o) Interest-bearing Loans and Borrowings (continued)
Gains and losses are recognised in profit or loss when the liabilities are derecognised.
Accounting policies applicable for the year ending 31 December 2004
All loans were measured at the principal amount. Interest was recognised as an expense as it accrued.
Bills of exchange and promissory notes were carried at the principal amount plus deferred interest.
(p) Provisions
Provisions are recognised when the Company has a present obligation (legal or constructive) as a result of a past event, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation and a reliable estimate can be made of the amount of the obligation.
Where the Company expects some or all of a provision to be reimbursed, for example under an insurance contract, the reimbursement is recognised as a separate asset but only when the reimbursement is virtually certain. The expense relating to any provision is presented in the Income Statement net of any reimbursement.
If the effect of the time value of money is material, provisions are discounted using a current pre-tax rate that reflects the risks specific to the liability.
When discounting is used, the increase in the provision due to the passage of time is recognised as a finance cost.
(q) Employee Leave Benefits
Liabilities for wages and salaries, including non-monetary benefits, annual leave and accumulating sick leave expected to be settled within 12 months of the reporting date are recognised in other payables in respect of employees’ services up to the reporting date. They are measured at the amounts expected to be paid when the liabilities are settled. Liabilities for non-accumulating sick leave are recognised when the leave is taken and are measured at the rates paid or payable.
(r) Share-based Payment Transactions
The Company provides benefits to employees (including directors) of the Company in the form of share-based payment transactions, whereby employees render services in exchange for shares or rights over shares (‘equity-settled transactions’).
The Company currently provide these benefits through:
(i)   options issued to executives and employees as part of a remuneration package issued in accordance with the power contained in the Company’s constitution, and
 
(ii)   the Employee Share Option Plan (ESOP).
The cost of these equity-settled transactions with employees is measured by reference to the fair value at the date at which they are granted. The fair value is determined using a Black-Scholes model, further details of which are given in Note 18.
In valuing equity-settled transactions, no account is taken of any performance conditions, other than conditions linked to the price of the shares of Metal Storm Limited (‘market conditions’).

F-16


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
3. Summary of Significant Accounting Policies (continued)
(r) Share-based Payment Transactions (continued)
The cost of equity-settled transactions is recognised, together with a corresponding increase in equity, over the period in which the performance conditions are fulfilled, ending on the date on which the relevant employees become fully entitled to the award (‘vesting date’).
The cumulative expense recognised for equity-settled transactions at each reporting date until vesting date reflects (i) the extent to which the vesting period has expired and (ii) the number of awards that, in the opinion of the Directors of the Company, will ultimately vest. This opinion is formed based on the best available information at balance date. No adjustment is made for the likelihood of market performance conditions being met as the effect of these conditions is included in the determination of fair value at grant date.
No expense is recognised for awards that do not ultimately vest, except for awards where vesting is conditional upon a market condition.
Where the terms of an equity-settled award are modified, as a minimum an expense is recognised as if the terms had not been modified. In addition, an expense is recognised for any Increase in the value of the transaction as a result of the modification, as measured at the date of modification.
Where an equity-settled award is cancelled, it is treated as if it had vested on the date of cancellation, and any expense not yet recognised for the award is recognised immediately. However, if a new award is substituted for the cancelled award, and designated as a replacement award on the date that it is granted, the cancelled and new award are treated as if they were a modification of the original award, as described in the previous paragraph.
The dilutive effect, if any, of outstanding options is reflected as additional share dilution in the computation of earnings per share (see Note 8).
The Company has applied the requirements of AASB 1 First-time Adoption of Australian Equivalents to International Financial Reporting Standards in respect of equity-settled awards and has applied AASB 2 Share-Based Payments only to equity instruments granted after 7 November 2002 that had not vested on or before 1 January 2005.
Transfers of an entity’s equity instruments by its shareholders to parties that have supplied goods or services to the entity (including employees) are considered share-based payments. These instruments are measured at the fair value of goods or services received. Where the fair value of the goods or services can not be reliably measured the Company measures the fair value of the equity instruments granted.
(s) Leases
The determination of whether an arrangement is or contains a lease is based on the substance of the arrangement and requires an assessment of whether the fulfilment of the arrangement is dependent on the use of a specific asset or assets and the arrangement conveys a right to use the asset.
Finance leases, which transfer to the Company substantially all the risks and benefits incidental to ownership of the leased item, are capitalised at the inception of the lease at the fair value of the leased property or, if lower, at the present value of the minimum lease payments. Lease payments are apportioned between the finance charges and reduction of the lease liability so as to achieve a constant rate of interest on the remaining balance of the liability. Finance charges are recognised as an expense in profit or loss.
Capitalised leased assets are depreciated over the shorter of the estimated useful life of the asset and the lease term if there is no reasonable certainty that the Company will obtain ownership by the end of the lease term.
Operating lease payments are recognised as an expense in the Income Statement on a straight-line basis over the lease term. Lease incentives are recognised in the Income Statement as an integral part of the total lease expense.

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
3. Summary of Significant Accounting Policies (continued)
(t) Revenue Recognition
Revenue is recognised to the extent that it is probable that the economic benefits will flow to the Company and the revenue can be reliably measured. The following specific recognition criteria must also be met before revenue is recognised:
Sale of goods
Revenue is recognised when the significant risks and rewards of ownership of the goods have passed to the buyer and can be measured reliably. Risks and rewards are considered passed to the buyer at the time of delivery of the goods to and acceptance by the customer, and collectibility of the selling price is reasonably assured.
Rendering of services
Revenue is recognised when key milestones or deliverables specified within each agreement are achieved and accepted by all parties to the agreement, no performance obligation with respect to the milestone or deliverable remains, the arrangement fee is fixed, and collectibility is reasonably assured.
Interest
Revenue is recognised as the interest accrues.
(u) Government Grants
Government grants are recognised when there is reasonable assurance that the grant will be received and all attaching conditions have been complied with.
When the grant relates to an expense item, it is recognised as income over the periods necessary to match the grant on a systematic basis to the costs that it is intended to compensate.
Where the grant relates to an asset, the fair value is credited to a deferred income account and is released to the Income Statement over the expected useful life of the relevant asset by equal annual instalments.
(v) Income Tax
Deferred Income tax is provided on all temporary differences at the balance sheet date between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes.
Deferred income tax liabilities are recognised for all taxable temporary differences:
  except where the deferred income tax liability arises from the initial recognition of an asset or liability in a transaction that is not a business combination and, at the time of the transaction, affects neither the accounting profit nor taxable profit or loss; and
 
  in respect of taxable temporary differences associated with investments in subsidiaries, associates and interests in joint ventures, except where the timing of the reversal of the temporary differences can be controlled and it is probable that the temporary differences will not reverse in the foreseeable future.
Deferred income tax assets are recognised for all deductible temporary differences, carry-forward of unused tax assets and unused tax losses, to the extent that it is probable that taxable profit will be available against which the deductible temporary differences, and the carry-forward of unused tax assets and unused tax losses can be utilised:

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
3. Summary of Significant Accounting Policies (continued)
(v) Income Tax (continued)
  except where the deferred income tax asset relating to the deductible temporary difference arises from the initial recognition of an asset or liability in a transaction that is not a business combination and, at the time of the transaction, affects neither the accounting profit nor taxable profit or loss; and
 
  in respect of deductible temporary differences associated with investments in subsidiaries, associates and interests in joint ventures, deferred tax assets are only recognised to the extent that it is probable that the temporary differences will reverse in the foreseeable future and taxable profit will be available against which the temporary differences can be utilised.
The carrying amount of deferred income tax assets is reviewed at each balance sheet date and reduced to the extent that it is no longer probable that sufficient taxable profit will be available to allow all or part of the deferred Income tax asset to be utilised.
Unrecognised deferred income tax assets are reassessed at each balance sheet date and are recognised to the extent that it has become probable that future taxable profit will allow the deferred tax asset to be recovered.
Deferred income tax assets and liabilities are measured at the tax rates that are expected to apply to the year when the asset is realised or the liability is settled, based on tax rates (and tax laws) that have been enacted or substantively enacted at the balance sheet date.
Income taxes relating to items recognised directly in equity are recognised in equity and not in the Income Statement.
Deferred tax assets and deferred tax liabilities are offset only if a legally enforceable right exists to set off current tax assets against current tax liabilities and the deferred tax assets and liabilities relate to the same taxable entity and the same taxation authority.
(w) Other Taxes
Revenues, expenses and assets are recognised net of the amount of GST except:
• where the GST incurred on a purchase of goods and services is not recoverable from the taxation authority, in which case the GST is recognised as part of the cost of acquisition of the asset or as part of the expense item as applicable; and
• receivables and payables are stated with the amount of GST included.
The net amount of GST recoverable from, or payable to, the taxation authority is included as part of receivables or payables in the balance sheet.
Cash flows are included in the Cash Flow Statement on a gross basis and the GST component of cash flows arising from investing and financing activities, which is recoverable from, or payable to, the taxation authority are classified as operating cash flows.
Commitments and contingencies are disclosed net of the amount of GST recoverable from, or payable to, the taxation authority.
(x) Financial Instruments Issued by the Company
Transaction Costs on the Issue of Equity Instruments
Transaction costs arising on the issue of equity instruments are recognised directly in equity as a reduction of the proceeds of the equity instruments to which the costs relate. Transaction costs are the costs that are incurred directly in connection with the issue of those equity instruments and which would not have been incurred had those instruments not been issued.

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
3. Summary of Significant Accounting Policies (continued)
(x) Financial Instruments Issued by the Company (continued)
Interest and Dividends
Interest and dividends are classified as expenses or as distributions of profit consistent with the balance sheet classification of the related debt or equity instruments or component parts of compound instruments.
(y) Technology Development
Expenditure by third parties to model and further develop the existing Metal Storm technology has not been recognised as an asset. This expenditure is not administered by the Company; however, the Company retains the ownership of key elements of the intellectual property that is produced by these programs.
(z) AASB 1 transitional exemption
The Company has made its election in relation to the transitional exemptions allowed by AASB 1 First-time Adoption of Australian Equivalents to International Financial Reporting Standards as follows:
Business combinations
AASB 3 Business Combinations was not applied retrospectively to past business combinations (i.e. business combinations that occurred before the date of transition to AIFRS).
Share-based payment transactions
AASB 2 Share-Based Payments is applied only to equity instruments granted after 7 November 2002 that had not vested on or before 1 January 2005.
Exemption from the requirement to restate comparative information for AASB 132 and AASB 139
The Company has elected to adopt this exemption and has not applied AASB 132 Financial Instruments: Presentation and Disclosure and AASB 139 Financial Instruments: Recognition and Measurement to its comparative information.
The effect of the changes in AASB 132 and AASB 139 have been considered and there is no financial impact on the comparative information contained in the financial statements.
(aa) Change in Financial Statement Basis and Presentation Currency
Historically, the Company has prepared its financial statements for inclusion in its annual report on Form 20-F in U.S. dollars and in accordance with accounting principles generally accepted in the United States (USGAAP).
In 2005, the Company has presented its financial statements in Australian dollars and in accordance with Australian Equivalents to International Financial Reporting Standards (AIFRS) which as applied by the Company also complies with International Financial Reporting Standards (IFRS) and interpretations adopted by the International Accounting Standards Board.
The reconciliation and explanation of the significant difference between AIFRS and USGAAP is contained in notes 30, 31 and 32 of this report.
(bb) Comparative Amounts
Certain balances have been reclassified in order to comply with the presentation adopted in the current year.

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
4. Segment Information
The Company operates in research and development of ballistics technology. Geographically, the Company operates in two predominant segments being Australia and the United States.
The Company’s primary reporting format is business segments.
The operating businesses are organised and managed as one business unit.
Business segments
The following tables present revenue and profit information and certain asset and liability information regarding business segments for the years ended 31 December 2005 and 2004.
                                 
    Research &   Discontinued        
    Development   Operation   Elimination   Consolidated
    A$   A$   A$   A$
     
2005
                               
Revenue
                               
Sales to customers outside the economic entity
    230,743       1,287,223               1,517,966  
     
Total segment revenue
    230,743       1,287,223               1,517,966  
Non-segment revenue
                               
Interest revenue
    599,902       3,047             602,949  
     
Total consolidated revenue
    830,645       1,290,270             2,120,915  
     
 
                               
Result
                               
Segment results
    (15,811,766 )     (1,541,729 )     6,197,640       (11,155,855 )
Unallocated expenses
    (310,908 )                 (310,908 )
     
Profit/(loss) before tax and finance costs
    (16,122,674 )     (1,541,729 )     6,197,640       (11,466,763 )
Finance costs
    (35,496 )     (60,661 )           (96,157 )
     
Profit/(loss) before income tax
    (16,158,170 )     (1,602,390 )     6,197,640       (11,562,920 )
Income tax benefit
    648,320                     648,320  
     
Net loss for the year
    (15,509,850 )     (1,602,390 )     6,197,640       (10,914,600 )
     
 
                               
Assets and liabilities
                               
Segment assets
    7,900,790       25,731       (496,800 )     7,429,721  
Segment liabilities
    13,127,206       3,592,079       (15,069,426 )     1,649,859  
 
                               
Other segment information
                               
Capital expenditure
    104,292                   104,292  
Depreciation
    (69,686 )     (141,859 )           (211,545 )
Amortisation
    (48,214 )                 (48,214 )
 
                               
Cash flow information
                               
Net cash flow from operating activities
    (10,352,652 )     (888,607 )           (11,241,259 )
Net cash flow from investing activities
    (3,727,214 )     2,256,722             (1,470,492 )
Net cash flow from financing activities
    (75,865 )     (1,684,160 )           (1,760,025 )

F-21


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
4. Segment Information (continued)
Business segments (continued)
                                 
    Research &   Discontinued        
    Development   Operation   Elimination   Consolidated
    A$   A$   A$   A$
     
2004
                               
Revenue
                               
Sales to customers outside the economic entity
    42,636       5,309,298       (77,294 )     5,274,640  
Other revenue
          14,099             14,099  
     
Total segment revenue
    42,636       5,323,397       (77,294 )     5,288,739  
Non-segment revenue
                               
Interest revenue
    794,565       15,737             810,302  
     
Total consolidated revenue
    837,201       5,339,134       (77,294 )     6,099,041  
     
 
                               
Result
                               
Segment results
    (17,631,138 )     (1,252,663 )     6,216,902       (12,666,899 )
Unallocated expenses
    (474,537 )                 (474,537 )
     
Profit/(loss) before tax and finance costs
    (18,105,675 )     (1,252,663 )     6,216,902       (13,141,436 )
Finance costs
    (43,568 )     (342,041 )     90,174       (295,435 )
     
Profit/(loss) before tax
    (18,149,243 )     (1,594,704 )     6,307,076       (13,436,871 )
Income tax benefit
    332,744                   332,744  
     
Net loss for the year
    (17,816,499 )     (1,594,704 )     6,307,076       (13,104,127 )
     
 
                               
Assets and liabilities
                               
Segment assets
    19,082,535       4,649,742       (3,404,960 )     20,327,317  
Segment liabilities
    9,426,925       6,354,788       (11,654,389 )     4,127,324  
 
                               
Other segment information
                               
Capital expenditure
    107,400       149,925             257,325  
Depreciation
    (98,341 )     (349,479 )           (447,820 )
Amortisation
    (16,953 )                 (16,953 )
 
                               
Cash flow information
                               
Net cash flow from operating activities
    (9,982,762 )     (1,253,893 )           (11,236,655 )
Net cash flow from investing activities
    683,872       (995,371 )           (311,499 )
Net cash flow from financing activities
    16,140,488       2,462,583             18,603,071  

F-22


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
4. Segment Information (continued)
Geographic Segment
The Company’s geographical segments are determined based on the location of the Company’s assets.
The following tables present revenue, expenditure and certain asset information regarding geographical segments for the years ended 31 December 2005 and 2004.
                                 
            North        
    Australia   America   Elimination   Consolidated
    A$   A$   A$   A$
     
2005
                               
Revenue
                               
Sales to customers outside the economic entity
          1,517,966               1,517,966  
Other revenue
    597,650       5,299               602,949  
Less revenue attributable to discontinued operations
          (1,290,270 )             (1,290,270 )
     
Revenue from continued operations
    597,650       232,995               830,645  
     
Total segment revenue
    597,650       232,995               830,645  
     
 
                               
Other segment information
                               
Segment assets
    7,388,239       538,282       (496,800 )     7,429,721  
Capital expenditure
    26,227       78,065               104,292  
 
                               
2004
                               
Revenue
                               
Sales to customers outside the economic entity
          5,351,934       (77,294 )     5,351,934  
Other revenue
    793,065       31,336             824,401  
Less revenue attributable to discontinued operations
          (5,261,840 )           (5,261,840 )
     
Revenue from continued operations
    793,065       121,430       (77,294 )     837,201  
     
Total segment revenue
    793,065       121,430       (77,294 )     837,201  
     
 
                               
Other segment information
                               
Segment assets
    18,379,503       5,352,774       (3,404,960 )     20,327,317  
Capital expenditure
    54,348       202,977             257,325  

F-23


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
5. Revenue and Expenses from Continuing Operations
                         
            2005   2004
            A$   A$
             
  (a )  
Revenue
               
       
Contract revenue
    230,743       42,636  
       
Interest revenue
    599,902       794,565  
             
       
 
    830,645       837,201  
             
       
 
               
  (b )  
Employee benefits expense
               
       
Wages & salaries
    (3,089,934 )     (2,502,161 )
       
Termination payments
    (500,000 )     (375,458 )
       
Superannuation
    (126,187 )     (79,109 )
       
Share-based payments expense
    (409,728 )     (277,779 )
       
Directors’ fees
    (310,908 )     (474,537 )
       
Fringe benefits tax
    (31,883 )     (42,415 )
             
       
 
    (4,468,640 )     (3,751,459 )
             
       
 
               
  (c )  
Lease payments included in the Income Statement in:
               
       
Facilities and equipment
    (370,311 )     (212,672 )
       
Communication and technology
    (71,506 )     (35,356 )
             
       
 
               
  (d )  
Finance Costs
               
       
Interest expense
    (35,496 )     (43,568 )
             
       
 
               
  (e )  
Depreciation, impairment and foreign exchange differences
               
       
Depreciation
    (69,686 )     (68,341 )
       
Amortisation
    (48,214 )     (16,953 )
       
Impairment of goodwill
          (1,834,152 )
       
Unrealised net foreign exchange difference
    (785 )     1,378  
       
Realised net foreign exchange difference
    (26,237 )     7,307  
             
6. Income Tax
The major components of income tax benefit are:
Income Statement
                 
Current income tax
               
Current income tax benefit
    (648,320 )     (332,744 )
     
Income tax benefit reported in the Income Statement
    (648,320 )     (332,744 )
     

F-24


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
6. Income Tax (continued)
A reconciliation between tax benefit and the product of accounting loss before income tax multiplied by the Group’s applicable income tax rate is as follows:
                 
    2005   2004
    A$   A$
     
Accounting loss before income tax from continuing operations
    (9,960,530 )     (11,921,112 )
Loss before tax from discontinued operation
    (1,602,390 )     (1,515,759 )
     
Accounting loss before income tax
    (11,562,920 )     (13,436,871 )
     
 
               
At the Group’s statutory income tax rate of 30% (2004: 30%)
    (3,468,876 )     (4,031,061 )
Other tax adjustments
    166,182       978,240  
Research & development — accounting expense add back
    266,774       66,549  
Research & development — current year tax offset
    (337,565 )      
Research & development — prior year tax offset
    (310,755 )     (332,744 )
Unrecognised tax losses
    3,035,920       2,986,273  
     
 
    (648,320 )     (332,744 )
     
Income tax benefit reported in the consolidated Income Statement
    (648,320 )     (332,744 )
Income tax attributable to discontinued operation
           
     
 
    (648,320 )     (332,744 )
     
                 
    Balance sheet
    2005   2004
    A$   A$
     
Deferred income tax
               
Deferred income tax at 31 December relates to the following:
               
 
               
CONSOLIDATED
               
 
               
Deferred tax assets
               
Provision — investment in ProCam Machine LLC
    575,216       575,216  
Sundry creditors and accruals
    55,230        
Employee entitlements
    42,040       84,521  
Asset retirement obligation
    13,508        
Deferred rent
    25,549        
S40-880 costs
    388,848       520,835  
Patent costs
    964,569       959,026  
Losses available for offset against future taxable income
    12,915,808       9,879,887  
     
 
               
Gross deferred income tax assets
    14,980,768       12,019,485  
     
Deferred tax assets not recognisable
    (14,980,768 )     (12,019,485 )
     
Deferred tax income/(expense)
           
     
Movement in the deferred tax assets not recognisable
                 
    2005   2004
    A$   A$
     
Deferred tax assets not recognisable at 1 January 2005
    (12,019,485 )     (7,872,311 )
Increase in unrecognised tax losses
    (3,035,920 )     (2,986,273 )
Decrease in deferred tax assets
    74,637       (1,160,901 )
Deferred tax assets utilised
             
     
Deferred tax assets not recognisable at 31 December 2005
    (14,980,768 )     (12,019,485 )
     
The valuation allowance increased by A$2,961,283 and $4,147,174 for the years ended 31 December 2005 and 2004, respectively.

F-25


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
6. Income Tax (continued)
Tax Loss Carryforwards
                 
    2005   2004
    A$   A$
     
Australian
    26,992,992       23,466,147  
United States — federal
    13,124,360       7,461,428  
United States — state
    9,160,116       5,153,678  
     
Total tax loss carryforwards
    49,277,468       36,081,253  
     
The Company has U.S. federal and state net operating loss carryforwards of approximately A$13,124,360 and A$9,160,116 which expire at various dates through 2025 and 2010, respectively.
The Company has tax losses arising in Australia of $26,992,992 (2004: $23,466,147) that are available indefinitely for offset against future taxable profits of the companies in which the losses arose, subject to satisfying the relevant income tax loss carry forward rules.
7. Discontinued Operation
The Company announced on 25 May 2005, that it had entered into a formal agreement to sell the ProCam Machine LLC (“ProCam”) business to Monroe Machined Products Inc. (“MMP”) of Seattle, Washington. The sale was completed on 1 June 2005. Under the terms of the sale agreement, MMP paid $2,256,721 for the fixed assets, current order book, inventory and the net of accounts receivable and accounts payable of ProCam. An additional amount of $65,615 was retained in trust contingent on the satisfaction of the conditions of the agreement. This amount has subsequently been paid to MMP.
The decision to sell ProCam was made to release valuable cash resources and management time to support the Company’s main focus in commercialising Metal Storm’s 40mm weapons system.
The results of ProCam for the period have been presented below:
                 
    2005   2004
    A$   A$
Revenue
    1,290,270       5,261,840  
Expenses
    (2,831,999 )     (6,525,732 )
 
               
Gross loss
    (1,541,729 )     (1,263,892 )
Finance costs
    (60,661 )     (251,867 )
 
               
Net loss attributable to discontinued operation
    (1,602,390 )     (1,515,759 )
 
               
Earnings per share (cents per share):
 
Basic and diluted from discontinued operation
    (0.31 )     (0.31 )
 
               

F-26


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
7. Discontinued Operation (continued)
The major classes of assets and liabilities of ProCam measured at the lower of carrying amount and fair value less costs to sell at 31 December are as follows:
                 
    2005   2004
    A$   A$
     
Assets
               
Cash and cash equivalents
          316,045  
Trade and other receivables
    23,373       393,596  
Inventory
          250,981  
Property plant and equipment
          2,753,319  
Other
    2,358       876,085  
 
               
Total Assets
    25,731       4,590,026  
Liabilities
               
Trade and other payables
    17,175       474,970  
Interest bearing liabilities
          1,684,160  
Provisions
    146,594       55,229  
 
               
Total Liabilities
    163,769       2,214,359  
 
               
Net Assets/(Liabilities)
    (138,038 )     2,375,667  
 
               
The net cash flows incurred by ProCam are as follows:
                 
Operating
    (888,607 )     (1,253,893 )
Investing
    2,256,722       (995,371 )
Financing
    (1,684,160 )     2,462,583  
 
           
Net cash inflow/(outflow)
    (316,045 )     213,319  
 
           
Details of disposal of ProCam are as follows:
Book value of the assets sold at 1 June 2005:
         
    2005
    A$
Accounts Receivable
    360,812  
Inventory
    456,510  
Property, plant and equipment
    2,212,631  
Accounts payable
    (77,946 )
Accrued property tax
    (36,681 )
 
       
Net assets attributable to discontinued operation
    2,915,326  
 
       
 
       
Consideration received as cash and cash equivalents
    2,256,721  
 
       
Loss on sale of the assets and liabilities
    (658,605 )
 
       

F-27


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
8. Earnings per Share
Basic earnings per share amounts are calculated by dividing net loss for the year attributable to ordinary equity holders of the parent by the weighted average number of ordinary shares outstanding during the year.
Diluted earnings per share is the same as basic earnings per share as the Company is in losses. As a result, the inclusion of the Company’s options in the diluted earnings per share calculation would be anti-dilutive and are therefore not considered.
The following reflects the income and share data used in the total operations basic and diluted earnings per share computations:
                 
    2005   2004
    A$   A$
Net loss attributable to ordinary equity holders of the parent from continuing operations
    (9,312,210 )     (11,588,368 )
Net loss attributable to ordinary equity holders of the parent from discontinued operation
    (1,602,390 )     (1,515,759 )
 
               
Net loss attributable to ordinary equity holders of the parent (used in calculating basic and diluted earnings per share)
    (10,914,600 )     (13,104,127 )
 
               
 
               
 
  Number   Number
Weighted average number of ordinary shares for basic and diluted earnings per share
    521,970,978       500,886,725  
 
               
There have been no other transactions involving ordinary shares since the reporting date and before the completion of these financial statements.

F-28


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
9. Cash and Cash Equivalents
                 
    2005   2004
    A$   A$
     
Cash at bank and in hand
    635,861       1,109,596  
Short term deposits
          14,000,000  
     
 
    635,861       15,109,596  
     
Cash at bank and in hand earns interest at floating rates based on daily bank deposit rates.
Short term deposits are made for varying periods of between one day and one month depending on the immediate cash requirements of the Company and earn interest at the respective short-term deposit rates.
At 31 December 2004, the Company had a line of credit facility for $829,889 with an interest rate of 5.5%. There were no similar facilities at 31 December 2005.
Reconciliation to Cash Flow Statement
For the purposes of the Cash Flow Statement, cash and cash equivalents comprise the following at 31 December:
                 
Cash at bank and in hand
    635,861       1,109,596  
Short term deposits
          14,000,000  
     
 
    635,861       15,109,596  
     
Reconciliation from the net loss after tax to the net cash flows from operations
                 
Net Loss
    (10,914,600 )     (13,104,127 )
Adjustments for:
               
Depreciation and amortisation
    259,759       464,773  
Net loss on disposal of discontinued operation
    658,605        
Foreign exchange (gains)/losses
    27,022       (19,694 )
Impairment loss on investment
          1,834,152  
Fair value of services paid for via issue of options
    409,728       801,445  
Fair value of services paid for via issue of shares
          111,595  
Inventory provision movements
          (90,415 )
Interest revenue
    (602,949 )     (810,302 )
 
               
Changes in assets and liabilities:
               
(Increase)/decrease in trade and other receivables
    (412,492 )     106,607  
(Increase)/decrease in inventories
    250,982       97,355  
(Increase)/decrease in prepayments
    (255,129 )     11,578  
(Decrease)/increase in trade and other payables
    (700,396 )     (484,279 )
(Decrease)/increase in provisions
    (55,049 )     (155,343 )
(Decrease)/increase in other current liabilities
    93,260        
 
               
     
Net cash from operating activities
    (11,241,259 )     (11,236,655 )
     

F-29


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
10. Available-for-sale Financial Investments
                 
    2005   2004
    A$   A$
     
Securities — Fair value
    5,056,140        
Available-for-sale financial investments consist of fixed interest securities.
These securities have a maturity date ranging from one to six years from the purchase date. The Company does not intend to hold the securities until maturity. Interest is paid quarterly in arrears and the securities can be redeemed upon three days notice.
11. Trade and Other Receivables
                         
Current
                       
Trade receivables
    (i)       98,532       377,057  
Goods and services tax — recoverable
            107,564       70,824  
Interest receivable
            17,695       33,740  
Income tax receivable
            337,565        
Other
            88,167       107,342  
Provision for doubtful debts
  (ii)     (27,750 )      
             
 
            621,773       588,963  
Related party receivables:
  (iii)                
Key management personnel
            13,436       1,225  
             
 
            635,209       590,188  
             
 
                       
Non-current
                       
Other
            8,832       3,397  
             
 
(i)   Trade receivables are non-interest bearing and are generally on 30 day terms.
 
(ii)   Provision for doubtful debts is determined by assessing evidence as to the recoverability of each debt.
 
(iii)   For terms and conditions relating to related party receivables refer to Note 26 and Note 29(h).
Movements in provision for doubtful debts for the years 2005 and 2004 are shown below.
                 
Balance at 1 January
           
Arising during year
    27,750        
Utilised during year
           
     
Balance at 31 December
    27,750        
     

F-30


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
12. Inventories
                 
    2005   2004
    A$   A$
     
Raw materials (at cost)
          48,328  
Work-in-progress (at cost)
          161,154  
Finished goods
          115,303  
Provision for diminution in value
          (73,803 )
     
 
          250,982  
     
Movements in provision for diminution in stock value for the years 2005 and 2004 are shown below.
                 
Balance at 1 January
    73,803        
Arising during year
          86,606  
Utilised during year
    (73,803 )     (12,803 )
     
Balance at 31 December
          73,803  
     
13. Other Financial Assets
Current
                 
Short term deposit
          845,446  
     
This amount represents US $650,000 security for ProCam Machine LLC letter of credit facility which has since been discharged.
14. Interests in Controlled Entities
                                         
    Country of   Percentage of equity held    
    Incorporation   by the consolidated entity   Investment
            2005   2004   2005   2004
Metal Storm Inc.
  USA     49 %     49 %     2,920       2,920  
ProCam Machine LLC
  USA     100 %     100 %            
Metal Storm USA Limited
  USA     100 %     100 %            
Digigun LLC
  USA     100 %     100 %            
The structure of Metal Storm Inc. allows the Company to bid directly on US defence projects under the Small Business Innovation Research (SBIR) program as the ‘prime’ contractor, thus enabling revenue flows directly into the Company. To be compliant with the requirements of the US Department of Defence, it was necessary to create Metal Storm Inc. as a 49% owned entity by Metal Storm Limited, and place the other 51% in trust for the benefit of Metal Storm Inc.’s US resident employees. For the purposes of financial reporting, Metal Storm continues to control Metal Storm Inc. and consolidates 100% of the assets and liabilities of this subsidiary.

F-31


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
15. Property, Plant and Equipment
                 
    2005   2004
    A$   A$
     
Leasehold improvements
               
At 1 January, net of accumulated depreciation
    35,059       19,805  
Additions
    726       28,991  
Depreciation charge for the year
    (15,715 )     (13,737 )
     
At 31 December, net of accumulated depreciation
    20,070       35,059  
     
 
               
At 1 January
               
Cost
    62,658       33,667  
Accumulated depreciation
    (27,599 )     (13,862 )
     
Net carrying amount
    35,059       19,805  
     
 
               
At 31 December
               
Cost
    63,384       62,658  
Accumulated depreciation
    (43,314 )     (27,599 )
     
Net carrying amount
    20,070       35,059  
     
 
               
Plant and equipment
               
At 1 January, net of accumulated depreciation
    2,912,745       3,270,967  
Additions
    103,566       228,334  
Attributable to discontinued operation
    (2,608,922 )      
Depreciation charge for the year
    (195,830 )     (434,083 )
Exchange adjustment
          (152,473 )
     
At 31 December, net of accumulated depreciation
    211,559       2,912,745  
     
 
               
At 1 January
               
Cost
    4,021,626       3,945,765  
Accumulated depreciation
    (1,108,881 )     (674,798 )
     
Net carrying amount
    2,912,745       3,270,967  
     
 
               
At 31 December
               
Cost
    492,216       4,021,626  
Accumulated depreciation
    (280,657 )     (1,108,881 )
     
Net carrying amount
    211,559       2,912,745  
     
 
               
Total property, plant and equipment
               
At 1 January, net of accumulated depreciation
    2,947,804       3,290,772  
Additions
    104,292       257,325  
Attributable to discontinued operation
    (2,608,922 )      
Depreciation charge for the year
    (211,545 )     (447,820 )
Exchange adjustment
          (152,473 )
     
At 31 December, net of accumulated depreciation
    231,629       2,947,804  
     
 
               
At 1 January
               
Cost
    4,084,284       3,979,432  
Accumulated depreciation
    (1,136,480 )     (688,660 )
     
Net carrying amount
    2,947,804       3,290,772  
     
 
               
At 31 December
               
Cost
    555,600       4,084,284  
Accumulated depreciation
    (323,971 )     (1,136,480 )
     
Net carrying amount
    231,629       2,947,804  
     

F-32


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
15. Property, Plant and Equipment (continued)
All property, plant and equipment is depreciated on a straight line basis over its useful life and assessed for impairment annually.
No impairment loss on property, plant and equipment was charged to the Income Statement for 2005 or 2004.
The carrying value of plant and equipment held under finance leases and hire purchase contracts at 31 December 2005 is $nil (2004: $1,339,390).
16. Intangible Assets and Goodwill
                 
    2005   2004
    A$   A$
     
Software
               
At 1 January, net of accumulated amortisation
    26,145       24,068  
Additions
    74,007       19,030  
Amortisation charge for the year
    (48,214 )     (16,953 )
     
At 31 December, net of accumulated amortisation
    51,938       26,145  
     
 
               
At 1 January
               
Cost
    48,882       29,852  
Accumulated amortisation
    (22,737 )     (5,784 )
     
Net carrying amount
    26,145       24,068  
     
 
               
At 31 December
               
Cost
    122,889       48,882  
Accumulated amortisation
    (70,951 )     (22,737 )
     
Net carrying amount
    51,938       26,145  
     
 
               
Goodwill
               
At 1 January, net of accumulated impairment
          1,631,412  
Additions
          202,740  
Impairment loss
          (1,834,152 )
     
At 31 December, net of accumulated impairment
           
     
 
               
At 1 January
               
Cost
    1,861,726       1,658,986  
Accumulated amortisation
    (27,574 )     (27,574 )
Accumulated impairment losses
    (1,834,152 )      
     
Net carrying amount
          1,631,412  
     
 
               
At 31 December
               
Cost
    1,861,726       1,861,726  
Accumulated amortisation
    (27,574 )     (27,574 )
Accumulated impairment losses
    (1,834,152 )     (1,834,152 )
     
Net carrying amount
           
     

F-33


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
16. Intangible Assets and Goodwill (continued)
                 
    2005   2004
    A$   A$
     
Total Intangibles
               
At 1 January, net of accumulated amortisation and impairment
    26,145       1,655,480  
Additions
    74,007       221,770  
Impairment loss
          (1,834,152 )
Amortisation charge for the year
    (48,214 )     (16,953 )
     
At 31 December, net of accumulated amortisation and impairment
    51,938       26,145  
     
 
               
At 1 January
               
Cost
    1,910,608       1,688,838  
Accumulated amortisation
    (50,311 )     (33,358 )
Accumulated impairment losses
    (1,834,152 )      
     
Net carrying amount
    26,145       1,655,480  
     
 
               
At 31 December
               
Cost
    1,984,615       1,910,608  
Accumulated amortisation
    (98,525 )     (50,311 )
Accumulated impairment losses
    (1,834,152 )     (1,834,152 )
     
Net carrying amount
    51,938       26,145  
     
All capitalised software represents externally acquired software with a useful life of between 2 and 5 years amortised on a straight line basis.
17. Impairment Testing of Goodwill
No impairment loss was recognised in the financial statements for the year ended 31 December 2005. For the year ended 31 December 2004, an impairment loss of $1,834,152.
The consolidated impairment loss represents impairment of goodwill which was allocated solely to ProCam Machine LLC (ProCam) which is a single cash generating unit and its own business segment (manufacturing) of the Company.
An impairment test was performed at 1 January 2004 in accordance with the accounting standards requirements that assets be tested for impairment on the date of the entities transition to AIFRS. At 30 June 2004 and 31 December 2004 an impairment test was triggered by ProCam posting results outside management’s expectations.
The recoverable amount of ProCam was determined by assessing its fair value less costs to sell. Fair value was determined using a discounted cash flow calculation using management’s cash flow forecasts for a period of two years.
At 30 June 2004 management reassessed the projected future cash flows of ProCam. These projections included expected cost savings from management initiatives, and anticipated revenue. Based on these projections, recoverable amount was in excess of carrying value and no impairment loss was recognised.
At 31 December 2004, management reassessed the estimated future cash flows of ProCam and based on the results of the six months prior and current business outlook determined that ProCam would not generate sufficient cash flows in the reasonable foreseeable future. Management determined the recoverable amount of the cash generating unit was zero based on fair value of liabilities in excess of fair value of assets at the date of assessment. As such the full balance of goodwill ($1,834,152) was impaired in the consolidated results.

F-34


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
17. Impairment Testing of Goodwill (continued)
The pre-tax discount rate applied to the cash flow projections was 14% based on management’s assessment of market rates for investments of similar expected cash flows and risk. The growth rate used to extrapolate cash flow projections was 3%.
18. Share-based Payment Plans
Options Issued under the Constitution
The Board issues options not pursuant to the Employee Share Option Plan as part of executive and senior employee remuneration packages. Inclusion of options as part of a remuneration package is at the absolute discretion of the Board. Each employment contract contains the specific details of the employees’ entitlement to options issued in this matter. Specifically the number of options the employee is entitled to, the exercise price, the vesting date and the expiry date of the options are all outlined in the employee contract.
The exercise price shall not be less than the market price of the Company’s shares on the date of signing the employment contract. The aggregate number of shares subject to options shall not exceed 5% of the Company’s shares then on issue. There are also individual limits on the number of options, which may be granted to employees.
An option shall lapse upon expiry of the exercise period.
The fair value of employee benefits are estimated at the date of grant using the Black-Scholes model. The following inputs were used in determining the value of options.
Expected volatility — calculated using historical information for a period equivalent to the expected life of the option dated back from the grant date of the options. This has a range between 54% and 72% depending on grant date and expected life of the options.
Risk-free interest rate — based on the implied yield on zero coupon Australian Government bonds with a maturity equal to the expected life of the option.
Expected life of the option — Range from four to eight years determined by the terms of the option agreement and managements’ assessment of when the option will be exercised.
Option exercise price — $0.40.
Share price — share price at grant date of the option.
The following table illustrates the number (No.) and weighted average exercise price (WAEP) of share options issued under the constitution.
                                                 
            2005           2004
            No.   WAEP           No.   WAEP
Outstanding at the beginning of the year
    (i )     12,399,353       0.28     (ii)     7,532,165       0.31  
Granted during the year
            3,268,750       0.40               6,042,188       0.44  
Exercised during the year
                                       
Expired during the year
            (204,165 )     0.87               (1,175,000 )     1.28  
                         
Outstanding at the end of the year
            15,463,938       0.30               12,399,353       0.28  
                         
 
                                               
Exercisable at the end of the year
            10,113,938       0.32               7,105,603       0.46  

F-35


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
18. Share-based Payment Plans (continued)
(i)   Included in this balance are options over 11,651,438 shares for which an expense has not been recognised in accordance with AASB 2 as the options were granted on or before 7 November 2002 or vest prior to 1 January 2005. These options have not subsequently been modified and therefore do not need to be accounted for in accordance with AASB 2.
 
(ii)   An additional 350,000 options were recognised upon transition to AIFRS on 1 January 2004.
The outstanding balance at 31 December is represented by:
                         
    Exercise Price        
Expiry Date   (A$)   2005 No.   2004 No.
 
9 April 2005
    1.162             31,250  
25 June 2005
    1.162             50,000  
3 September 2005
    0.400             25,000  
8 October 2005
    1.162             31,250  
17 October 2005
    0.556             16,665  
8 January 2006
    1.162       62,500       62,500  
3 March 2006
    0.400       55,000       55,000  
4 June 2006
    1.162       62,500       62,500  
3 September 2006
    0.556       12,500       12,500  
3 September 2006
    1.162       62,500       62,500  
19 October 2006
    0.400       118,000       118,000  
31 October 2006
    0.400       500,000       500,000  
31 October 2006
    0.556       12,500       12,500  
31 December 2006
    0.556       25,000       25,000  
6 February 2007
    0.556       12,500       12,500  
14 April 2007
    0.556       12,500       12,500  
14 September 2007
    0.556       12,500       12,500  
14 December 2007
    0.556       12,500       12,500  
31 December 2007
    0.400       6,250       6,250  
31 March 2008
    0.556       12,500       12,500  
4 June 2008
    0.388       5,000       5,000  
30 June 2008
    0.556       12,500       12,500  
30 September 2008
    0.556       12,500       12,500  
31 December 2008
    0.556       12,500       12,500  
14 January 2009
    0.400       125,000       125,000  
2 February 2009
    0.400       100,000       100,000  
16 February 2009
    0.400       14,438       14,438  
24 February 2009
    0.400       81,250       81,250  
10 March 2009
    0.400       8,250       8,250  
31 March 2009
    0.400       62,500       62,500  
31 March 2009
    0.556             12,500  
5 April 2009
    0.400       29,500       29,500  
14 April 2009
    0.400       1,100,000       1,100,000  
10 May 2009
    0.400       25,000       25,000  
8 June 2009
    0.400       25,000       25,000  
21 June 2009
    0.400       3,225,000       3,225,000  
21 June 2009
    1.100       40,000       40,000  
21 June 2009
    1.150       200,000       200,000  
30 June 2009
    0.400       62,500       62,500  
30 June 2009
    0.556             12,500  
5 July 2009
    0.400       75,000       75,000  
14 July 2009
    0.400       125,000       125,000  
4 September 2009
    0.400       31,250       31,250  
30 September 2009
    0.400       62,500       62,500  
30 September 2009
    0.556             12,500  
14 October 2009
    0.400       125,000       125,000  
24 November 2009
    0.400       6,250       6,250  
4 December 2009
    0.400       31,250       31,250  
7 December 2009
    0.400       12,500       12,500  
31 December 2009
    0.400       150,000       62,500  

F-36


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
18. Share-based Payment Plans (continued)
                         
    Exercise Price        
Expiry Date   (A$)   2005 No.   2004 No.
 
31 December 2009
    0.556             12,500  
31 March 2010
    0.400       200,000       112,500  
21 June 2010
    0.400       578,750        
24 June 2010
    0.400       1,990,000        
30 June 2010
    0.400       200,000       112,500  
30 September 2010
    0.400       200,000       112,500  
31 December 2010
    0.400       193,750       106,250  
31 March 2011
    0.400       131,250       43,750  
30 June 2011
    0.400       131,250       43,750  
2 July 2011
    0.010       5,000,000       5,000,000  
30 September 2011
    0.400       100,000       12,500  
 
            15,463,938       12,399,353  
             
Employee Share Option Plan
The Company operates a discretionary Employee Share Option Plan (ESOP) to enable the Board to provide an incentive and to reward full time executives and employees for the key role that they will play in the future success of the Company. A summary of the terms of the plan is as follows:
Invitations to participate in the ESOP are at the absolute discretion of the Board. Any invitation shall specify the precise details of the invitation, such as maximum number of shares, date by which application must be made by the invitee, the exercise price and any conditions attached to the exercise of the option. The exercise price shall not be less than the market price of the Company’s shares on the date determined by the Board. The aggregate number of shares subject to options shall not exceed 5% of the Company’s shares then on issue. There are also individual limits on the number of options, which may be granted to employees.
The exercise period is the earlier of: (a) the third anniversary of the date of grant of the option; (b) the date on which any special circumstances Including death, disability, redundancy, retirement or cessation of employment arise; (c) a takeover, compulsory acquisition, reconstruction, amalgamation or liquidation; and ending on the earliest of (d) the date which is 2 days before the tenth anniversary of the date of grant; (e) the last day before the first anniversary of the date on which any special circumstance arises; (f) the expiry of specific time frames set out in the Plan in relation to the circumstances in (c) above.
An option shall lapse upon expiry of the exercise period.
The Board may, at any time, cease making further offers or invitations but the subsisting rights of option holders shall not be affected.
There are currently no options issued under the ESOP.

F-37


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
19. Trade and Other Payables
                         
            2005   2004
            A$   A$
             
Trade payables
    (i)       609,134       414,150  
Other payables
  (ii)     161,856       1,101,883  
             
 
            770,990       1,516,033  
 
                       
Related party payables:
                       
Key management personnel
  (iii)     119,560       180,000  
             
 
            890,550       1,696,033  
             
 
(i) Trade payables are non interest-bearing and are normally settled on 30 day terms.
(ii) Other payables are non-interest bearing and have an average term of 30 days.
(iii) For terms and conditions relating to related party payables refer to Note 29(h).
The net of GST payable and GST receivable is remitted to the appropriate tax body on a quarterly basis.
20. Interest-bearing Loans and Borrowings
                         
Current
                       
Lease liability
    (i)             276,111  
Bank loan
  (ii)           829,890  
Other loan
  (iii)     353,674       372,835  
             
 
            353,674       1,478,836  
             
 
                       
Non-current
                       
Lease liability
                  578,160  
             
 
(i)   Leases have an average lease term on 5 years and a weighted average interest rate of 8.3%
 
(ii)   Bank loan bears interest at 4.6%
 
(iii)   Other loan bears interest at 4.1% (2004: 4.2%)
21. Provisions
Consolidated
                                 
    Asset   Onerous        
    Retirement   Lease        
    Obligation   Contracts   Payroll   Total
    A$   A$   A$   A$
     
At 1 January 2005
    41,403             332,496       373,899  
Arising during year
          136,203       176,936       313,139  
Utilised during year
                (413,213 )     (413,213 )
Discount rate accretion
    3,623                   3,623  
     
At 31 December 2005
    45,026       136,203       96,219       277,448  
     
 
                               
Current 2005
    45,026       136,203       96,219       277,448  
Non-current 2005
                       
     
 
    45,026       136,203       96,219       277,448  
     
 
                               
Current 2004
                332,496       332,496  
Non-current 2004
    41,403                   41,403  
     
 
    41,403             332,496       373,899  
     

F-38


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
21. Provisions (continued)
Asset retirement obligation
A provision is recognised to restore the leased premises to their original condition as required by the lease agreements. The amount recognised represents the present value of the estimated cost to restore the premises.
Onerous lease contract
Due to the sale of the assets of ProCam Machine LLC in 2005, the Company ceased using the premises in Seattle WA, United States. The lease for these premises expires in June 2007. The Company has been in discussions with the lessor who has indicated that they are prepared to terminate the lease early in exchange for consideration of US$100,000. This amount has been provided for in the financial statements.
Payroll
A provision has been recognised for payroll liabilities that include unused annual leave, long service leave and Fringe Benefits tax.
22. Contributed Equity and Reserves
                 
    2005   2004
    A$   A$
     
Ordinary Shares
               
Issued and fully paid
    56,559,039       56,559,039  
     
Share-based Payment Reserves
                                 
            Options   Accumulated    
    Options   granted not   unearned    
    reserve   yet issued   compensation   Total
     
Consolidated:
                               
At 1 January 2004
    1,107,864       70,568       (663,423 )     515,009  
Options granted during period
          232,920       (67,586 )     165,334  
Options issued during period
    358,332                   358,332  
Expenses recognised for the period
                277,779       277,779  
     
At 31 December 2004
    1,466,196       303,488       (453,230 )     1,316,454  
Options granted during period
          39,499       (39,499 )      
Options issued during period
    365,069       (251,824 )     (113,245 )      
Expenses recognised for the period
                409,728       409,728  
     
At 31 December 2005
    1,831,265       91,163       (196,246 )     1,726,182  
     
Other Reserves
                         
    Bond   Accumulated    
    valuation   translation    
    reserve   reserve   Total
     
Consolidated:
                       
At 1 January 2004
          (22,883 )     (22,883 )
Currency translation differences
          (120,003 )     (120,003 )
     
At 31 December 2004
          (142,886 )     (142,886 )
Currency translation differences
          48,101       48,101  
Net gains on available-for-sale financial assets
    36,660             36,660  
     
At 31 December 2005
    36,660       (94,785 )     (58,125 )
     

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
22. Contributed Equity and Reserves (continued)
Retained Losses
                 
    2005   2004
    A$   A$
     
At 1 January
    (41,532,634 )     (28,428,507 )
Net loss
    (10,914,600 )     (13,104,127 )
     
At 31 December
    (52,447,234 )     (41,532,634 )
     
Nature and purpose of reserves
Options reserve
The options reserve is used to record the share options issued to Directors, employees and consultants.
Options granted not yet issued
The options granted not yet issued reserve is used to record the options that have been granted but have not yet vested and therefore not been issued.
Accumulated unearned compensation
The accumulated unearned compensation reserve is used to record the value to the employee of options not yet vested. Upon vesting the reserve is reduced and the expense is recognised.
Bond valuation reserve
The bond reserve is used to record the movements for available-for-sale financial investments to fair value.
Accumulated translation reserve
The accumulated translation reserve is used to record exchange differences arising from the translation of the financial statements of foreign subsidiaries.
23. Financial Risk Management Objectives and Policies
The Company’s principal financial instruments comprise cash, short-term deposits and fixed interest rate securities. The main purpose of these financial instruments is to maximise the return on surplus cash while providing continuity of business.
The Company has various other financial instruments such as trade debtors and trade creditors, which arise directly from its operations.
It is, and has been throughout the period under review, the Company’s policy that no trading in financial instruments shall be undertaken.
The main risks arising from the Company’s financial instruments are interest rate risk, liquidity risk, foreign currency risk and credit risk. The board reviews and agrees policies for managing each of these risks and they are summarised below.
Interest rate risk
The Company’s exposure to market risk for changes in interest rates relates primarily to the Company’s investments of surplus funds.
Surplus funds are invested in fixed interest rate securities. The interest rate of these securities is adjusted to market rate at each reset date, usually quarterly, and the securities are able to be redeemed with three days notice.

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
23. Financial Risk Management Objectives and Policies (continued)
Foreign currency risk
As a result of maintaining an office in the United States, the Company’s balance sheet can be affected by movements in the US$/A$ exchange rates.
The Company also has transactional currency exposures. Such exposure arises from sales or purchases by an operating unit in currencies other than the unit’s measurement currency.
Approximately 40% of the Company’s purchases are denominated in currencies other than the reporting currency of the Company.
Credit risk
Credit risk refers to the risk that a counterparty will default on its contractual obligations resulting in financial loss to the Company.
The Company does not have any significant credit risk exposure to any single counterparty or any Company of counterparties having similar characteristics.
With respect to credit risk arising from the other financial assets of the Company, which comprise cash and cash equivalents and available-for-sale financial assets, the Company’s exposure to credit risk arises from default of the counter party, with a maximum exposure equal to the carrying amount of these instruments.
Liquidity risk
The Company’s objective is to maintain a balance between continuity of funding and maximisation of return on surplus funds.
The Company’s policy for investment of surplus funds is for all deposits to be rated AA by Moody’s. All investments are short term.
24. Financial Instruments
Fair values
Set out below is a comparison by category of carrying amounts and fair values of all the Company’s financial instruments that are carried in the financial statements at other than fair values.
                                 
    Carrying amount   Fair value
    2005   2004   2005   2004
    A$   A$   A$   A$
     
Consolidated
                               
Financial assets
                               
Cash
    635,861       15,109,596       635,861       15,109,596  
Trade receivables
    200,437       377,057       200,437       377,057  
Other receivables
    443,604       215,303       443,604       215,303  
     
 
                               
Financial liabilities
                               
Trade payables
    890,550       1,696,033       890,550       1,696,033  
Interest bearing loans
    353,674       2,056,996       353,674       2,056,996  
     

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
24. Financial Instruments (continued)
Interest rate risk
The following table details the carrying amount, by maturity, of the financial instruments that are exposed to interest rate risk.
Year ended 31 December 2005
Consolidated
                                                         
            1 to less   2 to less   3 to less   4 to less        
    Less than   than 2   than 3   than 4   than 5   More than    
    1 Year   Years   Years   Years   Years   5 Years   Total
    A$   A$   A$   A$   A$   A$   A$
     
Fixed rate
                                                       
Short term loans
    (353,674 )                                   (353,674 )
     
 
                                                       
Floating rate
                                                       
Cash
    635,861                                     635,861  
Fixed interest securities
    5,056,140                                     5,056,140  
     
Year ended 31 December 2004
Consolidated
                                                         
            1 to less   2 to less   3 to less   4 to less        
    Less than   than 2   than 3   than 4   than 5   More than    
    1 Year   Years   Years   Years   Years   5 Years   Total
    A$   A$   A$   A$   A$   A$   A$
     
Fixed rate
                                                       
Cash
    14,000,000                                     14,000,000  
Short term deposits
    845,446                                     845,446  
Bank loans
    (829,890 )                                   (829,890 )
Finance lease
    (276,110 )     (258,339 )     (124,682 )     (189,265 )     (5,874 )           (854,270 )
Short term loans
    (372,835 )                                   (372,835 )
     
 
                                                       
Floating rate
                                                       
Cash
    1,109,596                                     1,109,596  
     
                         
    Effective        
    interest   2005   2004
    rate %   A$   A$
             
Current
                       
Cash
    4.6       635,861       15,109,596  
Fixed interest securities
  BBSW + 1.3     5,056,140        
Short term deposits
    2.4             845,446  
Bank loans
    4.6             (829,890 )
Finance lease
    8.3             (276,110 )
Short term loans
    4.1       (353,674 )     (372,835 )
 
            5,338,327       14,476,207  
             
Short terms loans are unsecured and repayable in full by July 2006.
The 90 day BBSW rate can be found at the reserve bank of Australia website: http://www.rba.gov.au
                         
Non-current
                       
Finance lease
    8.3             578,160  
             

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
25. Commitments and Contingencies
Operating lease commitments — Company as lessee
The Company has entered into commercial property leases for its offices in Australia and the United States of America. The leases are operating leases and have remaining non-cancellable terms of between 1 and 5 years.
Future minimum rental payments under non-cancellable operating leases at 31 December are as follows:
                 
    2005   2004
    A$   A$
     
Within one year
    468,068       713,605  
After one year but not more than five years
    1,085,904       1,727,931  
More than 5 years
          288,887  
     
 
    1,553,991       2,730,423  
     
Contracts and Agreements
Singapore Technologies Kinetics Ltd (STK)
On 30 September 2005, Metal Storm Limited announced that it had signed a teaming agreement with STK to work co-operatively with STK in the development, production and marketing of 40mm munitions for Metal Storm weapon systems. Under the terms of this agreement, the Company agreed to provided funding amounting to $123,420 (SGD 150,000) through three milestone payments. The first payment of $30,466 (SGD 37,500) was made in November 2005 shortly after commencement of the program and the remaining two payments will be in the 2006 financial year upon the completion of agreed project objectives.
Potential claim concerning lease of two photocopies — ProCam Machine LLC
With the sale of ProCam to Monroe Machined Products in 1 June 2005, there were two photocopiers which were surplus to the consolidated entity’s requirements. These machines were leased and contact has been made with the lessor to arrange for removal of these machines and payout of any outstanding lease residual. As at the date of this report, the consolidated entity has been unable to ascertain the fair value of these machines and the payout for early termination of the lease. Accordingly no provision for any liability has been recognised in these financial statements.
Employment contracts
The employment contracts with Mr Ian Gillespie, Chief Operating Officer, Mr Jim MacDonald, Chief Financial Officer & Company Secretary, and Mr George Bergeron III, Chief Technology Officer, include a clause whereby upon a takeover, change of control or sale of the Company, these individuals are entitled to one year’s compensation, including bonus and options entitlements at full value and all options earned or held will vest immediately.

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
26. Related Party Disclosure
Mr James M. O’Dwyer
In February 2005, Metal Storm entered into a Separation Agreement with its major shareholder James M. O’Dwyer pursuant to which he was paid a retirement benefit of A$500,000 in recognition of his services to Metal Storm as its founder, a director and chief executive officer during our early years and, in more recent years, as an employee and consultant. In addition, Mr. O’Dwyer agreed to assign to Metal Storm certain intellectual property rights and agreed to certain non-competition arrangements.
Mr Bruce McComish
During 2005 and 2004, the Company utilised the services of BBY Limited, of which Mr Bruce McComish was a Director until 18 April 2005. During 2005 and 2004 the Company has paid fees of $100,000 and $23,606 respectively, to BBY Limited for corporate advisory services provided.
Call option agreement
Gen Downing entered into a call option agreement with Mr J M O’Dwyer on 10 October 2003 under which Gen Downing may call for the transfer of up to 2,000,000 existing shares to him at an exercise price of $0.40 per share. The call option is exercisable on one or more occasions until 10 October 2013, but only if certain conditions are satisfied, including that, except in certain limited circumstances, Gen Downing remains a director of the Company until 10 October 2006.
An expense of $220,569 has been recognised in both 2005 and 2004 pertaining to this agreement as required under AASB 2 Share-based Payments. These amounts are included in “Employee expenses” in the Consolidated Income Statements. Refer to Note 3(r) for details of the basis of accounting applied.
27. Events after the Balance Sheet Date
On 27 April 2006 the Company announced it would undertake a capital raise in the form of a Share Purchase Plan. The capital raise was undertaken during May and the Company raised a total of A$2.7 million, net of transaction costs, which increased the number of shares on issue by 22,647,240.
On 8 May 2006 the Company announced a preliminary agreement with Harmony Capital Partners to raise a further A$27.5 million via a renounceable rights issue. This agreement included the provision of a one year working capital facility by Harmony which was finalised and announced on 16 June 2006.
The working capital facility allows Metal Storm to draw A$5 million if necessary to supplement the Company’s available cash resources.
Other than those mentioned above and those referred to in the financial statements or notes thereto, there has not been any matter or circumstance that has arisen since the end of the financial year, that has significantly affected, or may significantly affect, the operations of the consolidated entity, the results of those operations, or the state of affairs of the consolidated entity in future financial years.
28. Auditors’ Remuneration
Amounts received or due and receivable by Ernst & Young Australia for:
                 
    2005   2004
    A$   A$
     
An audit or review of the consolidated financial statements of the Company
    385,410       437,661  
Other services in relation to the Company
    31,500       6,279  
     
 
    416,910       443,940  
     

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
29. Director and Executive Disclosures
(a) Details of Key Management Personnel
     
Directors
   
T J O’Dwyer
  Non-executive Chairman
W A Downing
  Non-executive Deputy Chairman
D A Smith
  Managing Director and Chief Executive Officer — appointed CEO 8 February 2005 and Managing Director 25 May 2005 — resigned 28 May 2006
D L Alspach
  Non-executive Director — resigned 1 July 2006
B S McComish
  Non-executive Director
J M Crunk
  Non-executive Director — appointed 29 September 2005
P D Jonson
  Non-executive Director — appointed 7 February 2006
J M O’Dwyer
  Non-executive Director — resigned 8 February 2005
J D Heipt
  Non-executive Director — resigned 8 February 2005
 
   
Executives
   
I A Gillespie
  Chief Operating Officer
J D MacDonald
  Chief Financial Officer & Company Secretary
G L Bergeron III
  Chief Technology Officer
J C Chehansky
  Senior VP Business Development — appointed 1 December 2005 — resigned 1 May 2006
C A Vehlow
  Chief Executive Officer — resigned 17 December 2004
S Moser-Savage
  Company Secretary — resigned 8 October 2004
Other than the appointment of Dr Jonson, and the resignation of D A Smith, there were no other changes to key management personnel after reporting date and the date the consolidated financial statements were authorised for issue.
Including the Chief Executive Officer, there were five executives in the Company at reporting date, and four executives as at the date the consolidated financial statements were authorised for issue.
(b) Compensation of Key Management Personnel
(i) Compensation policy
The performance of the Company depends upon the quality of its directors and executives. To prosper, the Company must attract, motivate and retain highly skilled directors and executives.
To this end, the Company embodies the following principles in its compensation framework:
  Provide competitive rewards to attract high calibre executives;
 
  Link executive rewards to long-term shareholder value;
 
  Significant portion of executive compensation ‘at risk’, dependent upon meeting pre-determined performance benchmarks; and
 
  Establish appropriate, demanding performance hurdles in relation to variable executive compensation.
(A) Remuneration Committee
The Remuneration Committee of the Board of Directors of the Company is responsible for determining and reviewing compensation arrangements for the Directors, the Chief Executive Officer (CEO) and all other key management personnel.
The Remuneration Committee assesses the appropriateness of the nature and amount of compensation of key management personnel on a periodic basis by reference to relevant employment market conditions, with the overall objective of ensuring maximum stakeholder benefit from the retention of a high quality Board and executive team.

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
29. Director and Executive Disclosures (continued)
(b) Compensation of Key Management Personnel (continued)
(B) Compensation structure
In accordance with best practice corporate governance, the structure of non-executive director and executive compensation is separate and distinct.
(C) Non-executive Director Compensation
Objective
The Board seeks to set aggregate compensation at a level which provides the Company with the ability to attract and retain directors of the highest calibre, whilst incurring a cost which is acceptable to shareholders.
Structure
The Constitution and the ASX Listing Rules specify that the aggregate compensation of non-executive directors shall be determined from time to time by a general meeting. An amount not exceeding the amount determined is then divided between the directors as agreed. The current aggregate amount is $500,000 per year.
The amount of aggregate compensation sought to be approved by shareholders and the manner in which it is apportioned amongst directors is reviewed by the Company annually. The Board considers advice from external consultants as well as the fees paid to non-executive directors of comparable companies when undertaking the annual review process.
Each Director receives a fee for being a Director of the Company. An additional fee may also be paid for each Board Committee on which a Director sits. The payment of additional fees for serving on a Committee recognises the additional time commitment required by Directors who serve on one or more sub Committees.
Non-executive Directors have long been encouraged by the Board to hold shares in the Company (purchased by the Director on market). It is considered good governance for directors to have a stake in the company on whose board they sit.
The compensation of non-executive Directors for the periods ended 31 December 2005 and 2004 is detailed in Note 29 (b)(G) of this report.
(D) Executive Compensation
Objective
The Company aims to reward executives with a level and mix of compensation commensurate with their position and responsibilities within the Company and so as to:
  reward executives for Company and individual performance against targets set by reference to appropriate benchmarks;
 
  align the interests of executives with those of shareholders;
 
  link reward with the strategic goals and performance of the Company; and
 
  ensure total compensation is competitive by market standards.
Structure
In determining the level and make-up of executive compensation, the Remuneration Committee considers market levels of compensation for comparable roles and makes its recommendations to the Board.
Employment contracts have been entered into with a number of key management personnel. Details of these contracts are provided in Note 29 (b)(I).
Compensation consists of the following key elements:
    Fixed Compensation
 
    Variable Compensation — Short Term Incentive (‘STI’);
The proportion of fixed compensation and variable compensation is established for each key management personnel by the Remuneration Committee. Note 29 (b) (G) details the fixed and variable components (%) of the key management personnel of the Group.

F-46


Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars) (continued)
For the Years Ended 31 December 2005 and 2004
29. Director and Executive Disclosures (continued)
(b) Compensation of Key Management Personnel (continued)
(E) Fixed Compensation
Objective
The level of fixed compensation is set so as to provide a base level of compensation which is both appropriate to the position and is competitive in the market.
Fixed compensation is reviewed annually by the Remuneration Committee and the process consists of a review of companywide and individual performance, relevant comparative compensation in the market and internally and, where appropriate, external advice on policies and practices.
Structure
Executives are given the opportunity to receive their fixed (primary) compensation in a variety of forms including cash and fringe benefits such as novated motor vehicle leases, superannuation salary sacrifice arrangements and expense payment plans. It is intended that the manner of payment chosen will be optimal for the recipient without creating extra cost for the Company.
(F) Variable Compensation — Short Term Incentive (STI)
Objective
The objective of the STI program is to link the achievement of the Company’s operational targets with the compensation received by the executives charged with meeting those targets. The total potential STI available is set at a level so as to provide sufficient incentive to the executive to achieve the operational targets and such that the cost to the Company is reasonable in the circumstances.
Structure
Actual STI payments granted to each key management personnel depend on the extent to which specific operating targets set at the beginning of the financial year are met. The operational targets consist of a number of Key Performance Indicators (KPIs) covering both financial and non-financial measures of performance. Typically included are measures such as contribution to net operating results, risk management, productivity improvements and leadership/team contribution. The Company has predetermined benchmarks which must be met in order to trigger payments under the short term incentive scheme.
On an annual basis, after consideration of performance against KPIs, the individual performance of each executive is rated and taken into account when determining the amount, if any, of the short term incentive pool that is to be allocated to each executive.
The aggregate of annual STI payments available for executives across the Company is subject to the approval of the Remuneration Committee. Payments made are usually delivered as a cash bonus or the issue of options or shares.
The Remuneration Committee has recommended to the board that there will be no STI bonuses for the 2005 financial year in view of the Company’s present financial situation.

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Table of Contents

Metal Storm Limited, Notes to the Consolidated Financial Statements
(Australian Dollars)
For the Years Ended 31 December 2005 and 2004
29. Director and Executive Disclosures (continued)
(b) Compensation of Key Management Personnel (continued)
(ii) Compensation of Key Management Personnel (consolidated) for the year ended 31 December 2005
                                                                                 
                                                                            Total
                                                    Share Based   Termination           Performance
            Short -Term   Post Employment   Payment   Benefits   Total   Related
                                    Superannuation(10)                    
                            Non Monetary   /Life & Medical   Retirement                
            Salary & Fees   Cash Bonus   Benefits   Insurance(11)   Benefits   Options(12)            
            A$   A$   A$   A$       A$   A$   A$   %
 
Directors
                                                                               
T J O’Dwyer
            70,000                                           70,000        
W A Downing
    (1)(2)       110,111                               220,569             330,680        
D A Smith
    (3)(4)       278,123                   7,156                         285,279        
D L Alspach
    (5)       75,000                                           75,000        
B S McComish
            50,000                                           50,000        
J M Crunk
    (6)       27,015                                           27,015        
J M O’Dwyer
    (7)                         23,523                   500,000       523,523        
J D Heipt
    (7)                                                        
 
                                                                               
Executives