Microsoft has offered to buy Yahoo for around $44.6 billion in cash and shares, to better compete with Google in the market for online services.
The market for online advertising is increasingly dominated by one player, Microsoft said, and merging with Yahoo will allow it to offer a competitive alternative.
Microsoft expects the market for online advertising to almost double in size over the next three years, from $40 billion in 2007 to $80 billion by 2010. A merger will allow it to realize economies of scale and reduce capital costs as it addresses this market, it said.
"The combination of these two great teams would enable us to jointly deliver a broad range of new experiences to our customers that neither of us would have achieved on our own," said Ray Ozzie, chief software architect at Microsoft, in a statement.
Microsoft expects to cut costs by $1 billion a year by realizing synergies with Yahoo in four areas: obtaining economies of scale as its audience increases; combining its research and development efforts with Yahoo's to innovate faster; eliminating operational redundancy to cut costs, and pooling expertise to innovate in video and mobile.
The companies will work together to develop the merger plan, Microsoft said.
It intends to pay key Yahoo engineers and other staff to stay following the merger.
The offer represents a 62 percent premium over Yahoo's closing price on Thursday. Microsoft expects to receive all necessary approvals in the second half of this year.