10. Share-Based Compensation

We maintain long-term incentive plans for management, key employees and the nonemployee members of our board of directors. The plans allow for the granting of equity-based compensation awards, including nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock awards, stock- and cash-settled restricted stock units, stock grants or a combination of awards. To date, we have not awarded any incentive stock options.

The majority of associates who receive share-based compensation awards primarily receive cash-settled restricted stock units. Senior management and other key associates receive awards of nonqualified stock options and stock-settled restricted stock units. Nonemployee directors receive awards of nonqualified stock options and stock grants.

Nonqualified Stock Options. Nonqualified stock options are awards that allow the recipient to purchase shares of our common stock at a fixed price. Stock options are granted at an exercise price equal to the fair market value of our common stock on the grant date. The stock options generally vest annually in equal amounts over periods of one to four years. These options are subject to forfeiture and expire no later than ten years after the date of the grant.

Cash-Settled Restricted Stock Units. Also referred to as restricted stock units, or RSUs, these are awards that entitle the holder to a cash payment equal to the fair market value of a share of our common stock for each unit granted. Conversion generally occurs at the end of a three-year vesting period. However, the cash payment per RSU will not be greater than 200% or less than 75% of the fair market value of a share of our common stock on the grant date. RSUs are liability awards that are subject to forfeiture and do not have voting rights.

Stock-Settled Restricted Stock Units. Also referred to as market stock units, or MSUs, these are awards to eligible key associates that are converted into between zero and two shares of common stock for each unit granted. Conversion generally occurs at the end of a three-year vesting period. The conversion ratio is calculated by dividing the average closing price of our stock during the final forty trading days of the three-year vesting period by our stock price on the grant date, with the resulting quotient capped at two. This quotient is then multiplied by the number of MSUs granted to yield the number of shares awarded. MSUs are subject to forfeiture and do not have voting rights.

Restricted Stock. Restricted stock awards are awards of our common stock that are subject to specified restrictions and a risk of forfeiture. The restrictions typically lapse three years from the grant date. Participants holding restricted stock are entitled to vote on matters submitted to holders of our common stock for a vote. No restricted stock awards have been granted since fiscal 2009, and no awards were outstanding as of February 29, 2012. We realized related tax benefits of $10.9 million from the vesting of restricted stock during the six months ended August 31, 2011.

Composition of Share-Based Compensation Expense


	Three Months Ended				Six Months Ended
	August 31				August 31
(In thousands)	2012		2011		2012		2011
Cost of sales	$	682	$	414	$	1,097	$	689
CarMax Auto Finance income		651		506		1,129		862
Selling, general and administrative expenses		13,559		10,638		28,483		25,241
Share-based compensation expense, before income taxes	$	14,892	$	11,558	$	30,709	$	26,792

Composition of Share-Based Compensation Expense – By Grant Type


	Three Months Ended				Six Months Ended
	August 31				August 31
(In thousands)	2012		2011		2012		2011
Nonqualified stock options	$	5,528	$	4,899	$	14,241	$	12,885
Cash-settled restricted stock units		5,692		3,520		8,392		6,867
Stock-settled restricted stock units		2,844		2,292		7,023		5,838
Employee stock purchase plan		278		265		503		489
Stock grants to non-employee directors		550		550		550		550
Restricted stock		―		32		―		163
Share-based compensation expense, before income taxes	$	14,892	$	11,558	$	30,709	$	26,792

We recognize compensation expense for stock options, MSUs and restricted stock on a straight-line basis (net of estimated forfeitures) over the requisite service period, which is generally the vesting period of the award. The variable expense associated with RSUs is recognized over their vesting period (net of estimated forfeitures) and is calculated based on the volume-weighted average price of our common stock on the last trading day of each reporting period. The total costs for matching contributions for our employee stock purchase plan are included in share-based compensation expense. There were no capitalized share-based compensation costs as of or for the six months ended August 31, 2012 or 2011.

Stock Option Activity


					Weighted
					Average
			Weighted		Remaining		Aggregate
	Number of		Average		Contractual		Intrinsic
(Shares and intrinsic value in thousands)	Shares		Exercise Price		Life (Years)		Value
Outstanding as of February 29, 2012		12,578	$	19.84
Options granted		2,234		31.60
Options exercised		(792)		15.86
Options forfeited or expired		(33)		24.70
Outstanding as of August 31, 2012		13,987	$	21.93		3.8	$	127,631
Exercisable as of August 31, 2012		9,221	$	18.61		2.9	$	112,031

For the six months ended August 31, 2012 and 2011, we granted nonqualified options to purchase 2,233,624 and 1,933,690 shares of common stock, respectively. The total cash received as a result of stock option exercises for the six months ended August 31, 2012 and 2011, was $12.6 million and $14.0 million, respectively. We settle stock option exercises with authorized but unissued shares of our common stock. The total intrinsic value of options exercised for the six months ended August 31, 2012 and 2011, was $12.2 million and $13.2 million, respectively. We realized related tax benefits of $4.9 million and $5.2 million during the six months ended August 31, 2012, and 2011, respectively.

Outstanding Stock Options


					As of August 31, 2012
					Options Outstanding						Options Exercisable
							Weighted
							Average		Weighted				Weighted
							Remaining		Average				Average
(Shares in thousands)					Number of		Contractual		Exercise		Number of		Exercise
Range of Exercise Prices					Shares		Life (Years)		Price		Shares		Price
$	7.14	-	$	10.75		482		0.6	$	7.15		482	$	7.15
$	11.43					2,196		3.6	$	11.43		1,618	$	11.43
$	13.19	-	$	14.81		2,044		2.3	$	13.83		2,044	$	13.83
$	14.86	-	$	19.82		2,033		2.4	$	19.22		2,033	$	19.22
$	19.98	-	$	25.12		1,304		1.9	$	24.78		1,233	$	24.84
$	25.39	-	$	30.24		1,851		4.5	$	25.56		1,019	$	25.41
$	31.76	-	$	32.05		2,189		6.6	$	31.76		140	$	31.77
$	32.69	-	$	33.11		1,888		5.6	$	32.70		652	$	32.70
Total						13,987		3.8	$	21.93		9,221	$	18.61

For stock options, the fair value of each award is estimated as of the date of grant using a binomial valuation model. In computing the value of the option, the binomial model considers characteristics of fair-value option pricing that are not available for consideration under a closed-form valuation model (for example, the Black-Scholes model), such as the contractual term of the option, the probability that the option will be exercised prior to the end of its contractual life and the probability of termination or retirement of the option holder. For this reason, we believe that the binomial model provides a fair value that is more representative of actual experience and future expected experience than the value calculated using a closed-form model. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by the recipients of share-based awards.

The weighted average fair value per share at the date of grant for options granted during the six months ended August 31, 2012 and 2011, was $12.68 and $13.84, respectively. The unrecognized compensation costs related to nonvested options totaled $41.9 million as of August 31, 2012. These costs are expected to be recognized on a straight-line basis over a weighted average period of 2.5 years.

Assumptions Used to Estimate Option Values


	Six Months Ended August 31
	2012					2011
Dividend yield				0.0	%				0.0	%
Expected volatility factor ⁽¹⁾	32.4	%	-	51.4	%	34.8	%	-	51.0	%
Weighted average expected volatility				49.4	%				49.3	%
Risk-free interest rate ⁽²⁾	0.02	%	-	2.0	%	0.01	%	-	3.5	%
Expected term (in years) ⁽³⁾				4.7					4.6

⁽¹⁾ Measured using historical daily price changes of our stock for a period corresponding to the term of the options and the implied volatility derived from the market prices of traded options on our stock.

⁽²⁾ Based on the U.S. Treasury yield curve in effect at the time of grant.

⁽³⁾ Represents the estimated number of years that options will be outstanding prior to exercise.

Cash-Settled Restricted Stock Unit Activity


		Weighted
		Average
	Number of	Grant Date
(Units in thousands)	Units	Fair Value
Outstanding as of February 29, 2012	1,915	$	21.76
Stock units granted	644	$	31.76
Stock units vested and converted	(780)	$	11.53
Stock units cancelled	(58)	$	28.68
Outstanding as of August 31, 2012	1,721	$	29.90

For the six months ended August 31, 2012 and 2011, we granted RSUs of 644,232 units and 575,380 units, respectively. The initial fair market value per unit at the date of grant for the RSUs granted during the six months ended August 31, 2012 and 2011, was $31.76 and $32.69, respectively. The RSUs are cash-settled upon vesting. For the six months ended August 31, 2012, we paid out $17.9 million before payroll tax withholdings upon the vesting of restricted stock units and realized tax benefits of $7.1 million.

Expected Cash Settlement Range Upon Restricted Stock Unit Vesting


	As of August 31, 2012
(In thousands)	Minimum ⁽¹⁾		Maximum⁽¹⁾
Fiscal 2014	$	10,583	$	28,220
Fiscal 2015		11,497		30,659
Fiscal 2016		12,645		33,721
Total expected cash settlements	$	34,725	$	92,600

⁽¹⁾ Net of estimated forfeitures.

Stock-Settled Restricted Stock Unit Activity


		Weighted
		Average
	Number of	Grant Date
(Units in thousands)	Units	Fair Value
Outstanding as of February 29, 2012	950	$	31.12
Stock units granted	347	$	40.36
Stock units vested and converted	(387)	$	16.67
Stock units cancelled	(6)	$	40.77
Outstanding as of August 31, 2012	904	$	41.00

For the six months ended August 31, 2012 and 2011, we granted MSUs of 346,551 units and 292,946 units, respectively. The fair value per unit at the date of grant for MSUs granted during the six months ended August 31, 2012 and 2011, was $40.36 and $45.58, respectively. The fair values were determined using a Monte-Carlo simulation and were based on the expected market price of our common stock on the vesting date and the expected number of converted common shares. We realized related tax benefits of $9.5 million for the six months ended August 31, 2012, from the vesting of market stock units. The unrecognized compensation costs related to nonvested MSUs totaled $19.7 million as of August 31, 2012. These costs are expected to be recognized on a straight-line basis over a weighted average period of 1.7 years.