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 The unexpected announcement Friday comes as Yahoo and Microsoft have fallen behind Google in the race to capture online advertising dollars. The deal could also give lift to the entire technology market.
The announcement sent Yahoo's share price up 54 percent in premarket trading.
In a letter to Yahoo's board of directors, Microsoft Chief Executive Steve Ballmer said the company will bid $31 per share, representing a 62 percent premium to Yahoo's closing stock price Thursday.
Since reaching a 52-week high of $34.08 in October, Yahoo shares have fallen 46 percent. Yahoo climbed $10.27 to $29.45 in premarket trading.
Ballmer said in the letter that Yahoo had told the world's biggest software company a year ago that the Yahoo board felt it was not the right time to enter into discussions regarding a deal.
"According to that letter, the principal reason for this view was the Yahoo board's confidence in the "potential upside" if management successfully executed on a reformulated strategy based on certain operational initiatives, such as Project Panama, and a significant organizational realignment."
"A year has gone by, and the competitive situation has not improved," Ballmer added.
Under terms of the proposed deal, Yahoo shareholders could choose to receive cash or Microsoft common shares, with the total purchase consisting of 50 percent each cash and stock.
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 Microsoft said it sees at least $1 billion cost savings generated by the merger, and intends to offer significant retention packages to Yahoo engineers, key leaders and employees. The software giant said it believes the takeover would receive regulatory clearance and close in the second half of 2008.
Ballmer said Microsoft expects Yahoo's board will review its proposal, but "reserves the right to pursue all necessary steps to ensure that Yahoo's shareholders are provided with the opportunity to realize the value inherent in our proposal."
The announcement follows Yahoo's announcement late Thursday that Terry Semel stepped down as chairman, severing his ties with Yahoo 7 1/2 months after he resigned as chief executive under shareholder pressure. He had been criticized for failing to cash in on the Web advertising surge as effectively as main rival Google Inc.
Yahoo co-founder and Chief Executive Jerry Yang said this week the company will cut 1,000 jobs, or 7 percent of its work force, in an effort to cut costs.
Meanwhile, Microsoft last week forecast a rosy 2008 -- despite broader economic worries
-- after it blew by Wall Street's expectations for a second consecutive quarter.
[Associated Press; By IRA PODELL]
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