(4) Stock-Based Compensation

We issue stock-based awards to certain of our employees and our Board of Directors and we recognize related stock-based compensation for both equity and liability-classified stock-based awards in our condensed consolidated financial statements. These awards are issued pursuant to our 2000 Stock Incentive Plan and our 2001 Employee Stock Purchase Plan (the “ESPP”). Historically, stock-based awards were granted in the form of stock options and, to a much lesser extent, stock appreciation rights ("SARs"). Commencing in fiscal 2012, we also began issuing restricted stock units ("RSUs") and, to a much lesser extent, stock units.

Stock-based compensation for equity-classified awards is measured at the date of grant, based on an estimate of the fair value of the award and is generally expensed over the vesting period of the award. We expect to settle all outstanding equity-based awards with new shares. Stock-based compensation for liability-classified awards is determined the same way, except that the fair value of liability-classified awards is remeasured at the end of each reporting period until the award is settled, with changes in fair value recognized pro-rata for the portion of the requisite service period rendered. In addition, SARS may only be settled with cash.

Stock-based compensation for awards issued is reflected in the following line items in our Condensed Consolidated Statements of Operations:



	Three months ended October 31,
	2012			2011
Cost of sales	$	45,000		53,000
Selling, general and administrative expenses	601,000			645,000
Research and development expenses	99,000			175,000
Stock-based compensation expense before income tax benefit	745,000			873,000
Income tax benefit	(264,000		)	(306,000	)
Net stock-based compensation expense	$	481,000		567,000

Stock-based compensation expense before income tax benefit, by award type, is summarized as follows:



	Three months ended October 31,
	2012			2011
Stock options	$	573,000		792,000
ESPP	53,000			61,000
RSUs with performance measures	86,000			—
RSUs without performance measures	32,000			—
Stock units	6,000			—
SARs	(5,000		)	20,000
Stock-based compensation expense before income tax benefit	$	745,000		873,000

There were no stock options granted during the three months ended October 31, 2012.

Stock options granted during the three months ended October 31, 2011 had exercise prices equal to the fair market value of the stock on the date of grant, a contractual term of ten years, a vesting period of five years and a per share weighted average grant-date fair value of $5.88. We estimate the fair value of stock options using the Black-Scholes option pricing model. The Black-Scholes option pricing model includes assumptions regarding dividend yield, expected volatility, expected option term and risk-free interest rates. In estimating the fair value of the stock options that were issued during the three months ended October 31, 2011, we utilized the following weighted average assumptions:



Expected dividend yield	4.04	%
Expected volatility	36.00	%
Risk-free interest rate	0.88	%
Expected life (years)	5.42

The expected dividend yield is the expected annual dividend as a percentage of the fair market value of the stock on the date of grant. For the stock options granted during the three months ended October 31, 2011, the expected dividend yield was equal to our targeted annual dividend of $1.10 per share, divided by the quoted market price of our common stock on the date of the grant. We estimate expected volatility by considering the historical volatility of our stock, the implied volatility of publicly-traded call options on our stock, the implied volatility of call options embedded in our 3.0% convertible senior notes and our expectations of volatility for the expected life of stock options. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for an instrument which closely approximates the expected option term. The expected option term is the number of years we estimate that stock options will be outstanding prior to exercise. The expected life of awards issued is determined by employee groups with sufficiently distinct behavior patterns.

RSUs with performance measures, that were granted to certain employees, vest over a 5.3 year period beginning on the date of grant, if pre-established performance goals are attained. As of October 31, 2012, we expect that the goals relating to RSUs with performance measures outstanding will be attained. RSUs without performance measures, that were granted to non-employee directors, have a vesting period of three years from the date of grant. The fair value of RSUs is based on the closing market price of our common stock on the date of grant, net of the present value of dividends using the applicable risk-free interest rate, as RSUs are not entitled to dividend equivalents while unvested and the underlying shares are unissued. RSUs with performance measures are convertible into shares of our common stock on a one-for-one basis at the end of each vesting tranche for no cash consideration. RSUs without performance measures are convertible into shares of our common stock generally at the time of termination, on a one-for-one basis for no cash consideration, or earlier under certain specific circumstances.

Fully-vested stock units granted during the three months ended October 31, 2012 were valued at $28.12 per share, the closing price of our common stock on the date of grant. Stock units granted are convertible into shares of our common stock generally at the time of termination, on a one-for-one basis for no cash consideration, or earlier under certain specific circumstances.

ESPP expense, reflected in the table above, for the three months ended October 31, 2012 and 2011 primarily relates to the 15% discount offered to employees participating in the ESPP.

Similar to our stock options, SARS that are outstanding at October 31, 2012 have exercise prices equal to the fair market value of our stock on the date of grant, a contractual term of five years, a vesting period of three years and are measured using the Black-Scholes option pricing model. Included in accrued expenses at October 31, 2012 and July 31, 2012 is $1,000 and $6,000, respectively, relating to the potential cash settlement of SARs.

Stock-based compensation that was capitalized and included in ending inventory at both October 31, 2012, and July 31, 2012 was $48,000.

At October 31, 2012, total remaining unrecognized compensation cost related to unvested stock-based awards was $8,514,000, net of estimated forfeitures of $596,000. The net cost is expected to be recognized over a weighted average period of 3.5 years.

The assumptions used in computing the fair value of stock-based awards reflect our best estimates, but involve uncertainties relating to market and other conditions, many of which are outside of our control. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by recipients of stock-based awards.

The following table provides the components of the actual income tax benefit recognized for tax deductions relating to the exercise of stock-based awards:



	Three months ended October 31,
	2012			2011
Actual income tax benefit recorded for the tax deductions relating to the exercise of stock-based awards	$	1,000		120,000
Less: Tax benefit initially recognized on exercised stock-based awards vesting subsequent to the adoption of accounting standards that require us to expense stock-based awards, excluding income tax shortfalls	(1,000		)	(99,000	)
Excess income tax benefit recorded as an increase to additional paid-in capital	—			21,000
Less: Tax benefit initially disclosed but not previously recognized on exercised equity-classified stock-based awards vesting prior to the adoption of accounting standards that require us to expense stock-based awards	—			(2,000	)
Excess income tax benefit from exercised equity-classified stock-based awards reported as a cash flow from financing activities in our Condensed Consolidated Statements of Cash Flows	$	—		19,000

As of October 31, 2012, the amount of hypothetical tax benefits related to stock-based awards was $19,890,000. During the three months ended October 31, 2012 and 2011, we recorded $2,892,000 and $1,021,000, respectively, as a reduction to additional paid-in capital and accumulated hypothetical tax benefits related to stock-based awards. Such amounts represent the reversal of unrealized deferred tax assets associated with certain vested equity-classified stock-based awards that expired during the period.