EQUITY COMPENSATION PLANS

Equity Compensation Overview. We have various equity compensation plans for employees, as well as for non-employee members of our board of directors. These include the General Dynamics Corporation 2009 Equity Compensation Plan and the 2012 Equity Compensation Plan (Equity Compensation Plans) and the 2009 General Dynamics United Kingdom Share Save Plan (U.K. Plan).

The Equity Compensation Plans seek to provide an effective means of attracting, retaining and motivating directors, officers and key employees, and to provide them with incentives to enhance our growth and profitability. Under the Equity Compensation Plans, awards may be granted to officers, employees or non-employee directors in common stock, options to purchase common stock, restricted shares of common stock, participation units or any combination of these.

Stock options may be granted either as incentive stock options, intended to qualify for capital gain treatment under Section 422 of the Internal Revenue Code (the Code), or as options not qualified under the Code. As a matter of practice, we do not currently grant incentive stock options. All options granted under the Equity Compensation Plans are issued with an exercise price at the fair market value of the common stock on the date of grant. Awards of stock options vest over two years, with 50 percent of the options vesting in one year and the remaining 50 percent vesting the following year. Stock options that have been awarded under the Equity Compensation Plans expire five or seven years after the grant date. We grant annual stock option awards to participants in the Equity Compensation Plans on the first Wednesday of March based on the average of the high and low stock prices on that day as listed on the New York Stock Exchange. On occasion, we may also make ad hoc grants at other times during the year for new hires or promotions.

Grants of restricted stock are awards of shares of common stock that are released approximately four years after the grant date. During that restriction period, recipients may not sell, transfer, pledge, assign or otherwise convey their restricted shares to another party. However, during the restriction period, the recipient is entitled to vote the restricted shares and receive cash dividends on those shares.

Participation units represent obligations that have a value derived from or related to the value of our common stock. These include stock appreciation rights, phantom stock units and restricted stock units (RSUs) and are payable in cash or common stock. Beginning in March 2012, we granted RSUs with a performance measure based on a management metric, return on invested capital (ROIC). Depending on the company’s performance with respect to this metric, the number of RSUs earned may be less than, equal to, or greater than the original number of RSUs awarded.

We issue common stock under our equity compensation plans from treasury stock. On December 31, 2012, in addition to the shares reserved for issuance upon the exercise of outstanding options, approximately 19 million shares have been authorized for options and restricted stock that may be granted in the future.

Stock-based Compensation Expense. Stock-based compensation expense is included in G&A expenses. The following table details the components of stock-based compensation expense recognized in net earnings in each of the past three years:



Year Ended December 31	2010		2011		2012
Stock options	$	53	$	58	$	57
Restricted stock	24		25		17
Total stock-based compensation expense, net of tax	$	77	$	83	$	74

Stock Options. We recognize compensation expense related to stock options on a straight-line basis over the vesting period of the awards, which is generally two years. We estimate the fair value of options on the date of grant using the Black-Scholes option pricing model with the following assumptions for each of the past three years:



Year Ended December 31	2010		2011		2012
Expected volatility	27.0-31.9%		28.4-31.5%		27.9-31.3%
Weighted average expected volatility	29.8	%	30.1	%	30.7	%
Expected term (in months)	40-50		43-53		43-53
Risk-free interest rate	1.0-2.2%		1.2-1.9%		0.6-0.8%
Expected dividend yield	2.0	%	2.0	%	2.7	%

We determine the above assumptions based on the following:


•	Expected volatility is based on the historical volatility of our common stock over a period equal to the expected term of the option.


•	Expected term is based on historical option exercise data used to determine the expected employee exercise behavior. Based on historical option exercise data, we have estimated different expected terms and determined a separate fair value for options granted for two employee populations.


•	The risk-free interest rate is the yield on a U.S. Treasury zero-coupon issue with a remaining term equal to the expected term of the option at the grant date.


•	The dividend yield is based on our historical dividend yield level.

The resulting weighted average fair value per option granted was $15.00 in 2010, $15.63 in 2011 and $13.23 in 2012. Stock option expense reduced operating earnings (and on a per-share basis) by $82 ($0.14) in 2010, $90 ($0.16) in 2011 and $88 ($0.16) in 2012. Compensation expense for stock options is reported as a Corporate expense for segment reporting purposes (see Note Q). On December 31, 2012, we had $56 of unrecognized compensation cost related to stock options, which is expected to be recognized over a weighted average period of one year.

A summary of option activity during 2012 follows:



	Shares Under Option		Weighted Average Exercise Price Per Share
Outstanding on December 31, 2011	29,304,653		$	69.19
Granted	5,650,767		70.81
Exercised	(3,722,749	)	40.57
Forfeited/cancelled	(5,107,912	)	76.52
Outstanding on December 31, 2012	26,124,759		$	72.19
Vested and expected to vest on December 31, 2012	25,811,443		$	72.19
Exercisable on December 31, 2012	17,004,811		$	72.30

Summary information with respect to our stock options’ intrinsic value and remaining contractual term on December 31, 2012, follows:



	Weighted Average Remaining Contractual Term (in years)	Aggregate Intrinsic Value (in millions)
Outstanding	3.2	$	76
Vested and expected to vest	3.1	76
Exercisable	1.8	73

In the table above, intrinsic value is calculated as the excess, if any, between the market price of our stock on the last trading day of the year and the exercise price of the options. For options exercised, intrinsic value is calculated as the difference between the market price on the date of exercise and the exercise price. The total intrinsic value of options exercised was $109 in 2010, $113 in 2011 and $112 in 2012.

We received cash from the exercise of stock options of $277 in 2010, $198 in 2011 and $146 in 2012. The excess tax benefit resulting from stock option exercises was $18 in 2010, $24 in 2011 and $29 in 2012.

Restricted Stock/Restricted Stock Units. We determine the fair value of restricted stock and restricted stock units as the average of the high and low market prices of our stock on the date of grant. We generally recognize compensation expense related to restricted stock and restricted stock units on a straight-line basis over the period during which the restriction lapses, which is generally four years.

Compensation expense related to restricted stock and restricted stock units reduced operating earnings (and on a per-share basis) by $36 ($0.06) in 2010, $38 ($0.07) in 2011 and $26 ($0.05) in 2012. On December 31, 2012, we had $52 of unrecognized compensation cost related to restricted stock and restricted stock units, which is expected to be recognized over a weighted average period of 2.3 years.

A summary of restricted stock and restricted stock unit activity during 2012 follows:



	Shares/ Share-Equivalent Units		Weighted Average Grant-Date Fair Value Per Share
Nonvested at December 31, 2011	2,421,033		$	63.01
Granted	532,354		70.86
Vested	(421,834	)	83.03
Forfeited	(38,104	)	67.53
Nonvested at December 31, 2012	2,493,449		$	61.23

The total fair value of shares vested was $30 in 2010, $28 in 2011 and $28 in 2012.