(10) Stock-Based Compensation

The fair value of all new and modified stock-based awards granted, net of estimated forfeitures, is recognized as compensation expense over the respective service period. Forfeiture estimates are based on historical experience.

Bancorp currently has one stock-based compensation plan. Initially, in the 2005 Stock Incentive Plan, there were 735,000 shares of common stock reserved for issuance of stock based awards. In 2010, shareholders approved an additional 700,000 shares of common stock for issuance under the plan. As of September 30, 2013, there were 505,012 shares available for future awards. Bancorp’s 1995 Stock Incentive Plan expired in 2005; however, options granted under this plan expire as late as 2015.

Options and stock appreciation rights (SARs) granted generally have been subject to a vesting schedule of 20% per year. Restricted shares generally vest over three to five years. All awards have been granted at an exercise price equal to the market value of common stock at the time of grant; options and SARs expire ten years after the grant date unless forfeited due to employment termination.

Grants of restricted stock units (RSUs) to executive officers vest based upon service and a three-year performance period which begins January 1 of the first year of the performance period. Because grantees are not entitled to dividend payments during the performance period, the fair value of these RSUs is estimated based upon the fair value of the underlying shares on the date of the grant, adjusted for non-payment of dividends.

Bancorp reduces future stock-based compensation expense by estimated forfeitures at the grant date. These forfeiture estimates are based on historical experience. Bancorp has recognized stock-based compensation expense, within salaries and employee benefits in the unaudited consolidated statements of income, as follows:

	For three months ended September 30,						For nine months ended September 30,
(in thousands)	2013			2012			2013			2012
Stock-based compensation expense before income taxes	$	488		$	378		$	1,473		$	1,118
Deferred tax benefit	(171		)	(132		)	(516		)	(391		)
Reduction of net income	$	317		$	246		$	957		$	727

Bancorp expects to record an additional $470,000 of stock-based compensation expense in 2013 for equity grants outstanding as of September 30, 2013. As of September 30, 2013, Bancorp has $3,607,000 of unrecognized stock-based compensation expense that is expected to be recorded as compensation expense over the next five years as awards vest. Bancorp received cash of $1,260,000 and $562,000 from the exercise of options during the first nine months of 2013 and 2012, respectively.

The fair value of Bancorp’s stock options and SARs is estimated at the date of grant using the Black-Scholes option pricing model, a leading formula for calculating the value of stock options and SARs. This model requires the input of subjective assumptions, changes to which can materially affect the fair value estimate. The fair value of restricted shares is determined by Bancorp’s closing stock price on the date of grant.

The following assumptions were used in option and SAR valuations at the grant date in each year:

	2013		2012

Dividend yield	2.80	%	2.52	%
Expected volatility	22.54		22.04
Risk free interest rate	1.26		1.44
Forfeitures	6.40		4.20
Expected life of options and SARs (in years)	6.6		7.6

The expected life of options and SARs is based on actual experience of past like-term options. Bancorp evaluates historical exercise and post-vesting termination behavior when determining the expected life.

Dividend yield and expected volatility are based on historical information corresponding to the expected life of options and SARs granted. Expected volatility is the volatility of the underlying shares for the expected term on a monthly basis. The risk free interest rate is the implied yield currently available on U.S. Treasury issues with a remaining term equal to the expected life of the options.

A summary of stock option and SARs activity and related information for the nine months ended September 30, 2013 follows:

											Weighted
					Weighted		Aggregate		Weighted		average
	Options				average		intrinsic		average		remaining
	and SARs		Exercise		exercise		value		fair		contractual
	(in thousands)		price		price		(in thousands)		value		life (in years)

At December 31, 2012
Vested and exercisable	681		$	20.17-26.83	$	23.42	$	271	$	5.33	3.5
Unvested	246		21.03-26.83		22.62		77		4.67		7.9
Total outstanding	927		20.17-26.83		23.21		348		5.15		4.7

Granted	54		22.89		22.89		292		3.61
Exercised	(117	)	20.17-26.83		21.49		557		4.74
Forfeited	(4	)	21.03-23.76		22.78		19		4.88

At September 30, 2013
Vested and exercisable	642		20.17-26.83		23.66		2,997		5.38		3.4
Unvested	218		21.03-24.87		22.70		1,228		4.36		7.9
Total outstanding	860		20.17-26.83		23.42		$	4,225	5.12		4.6

Vested during year	79		21.03-24.87		22.56		$	458	4.81

Intrinsic value for stock options and SARs is defined as the amount by which the current market price of the underlying stock exceeds the exercise price. In the first quarter of 2013, Bancorp granted 53,598 SARs at the current market price of $22.89 and a Black-Scholes fair value of $3.61. In the first quarter of 2013, Bancorp granted 55,275 shares of restricted common stock at the weighted average current market price of $22.93. In 2013 and 2012, Bancorp awarded performance-based RSUs with fair values of $20.38 and $20.57, respectively to executive officers of the Bank, the three-year performance period for which began January 1 of the award year. Bancorp believes the most likely vesting of all RSUs will be 62,389 shares of common stock. There were no grants of SARs or restricted common stock in the second or third quarters of 2013. No stock options have been granted since 2007.