Yahoo Inc. on Monday formally rejected Microsoft Corp.'s $44.6 billion bid to buy the company, saying the unsolicited offer " substantially undervalues" the Internet giant.

Microsoft (MSFT) later responded, calling the decision "unfortunate" but stopped short of saying it would not raise its offer. Microsoft said in a statement it reserves the right "to pursue all necessary steps" without specifying whether it plans to take its bid straight to Yahoo shareholders.

Still, analysts say Microsoft will probably raise its bid, originally valued at $31 a share, to at least $35, but could be persuaded to go as high as $40. Yahoo's statement did not suggest what price its board was seeking.

"The proposal is not in the best interests of Yahoo and our stockholders," Chief Executive Jerry Yang wrote in an e-mail to employees on Monday. "We believe Microsoft's proposal substantially undervalues Yahoo."

Microsoft wants to complete the largest-ever computer technology merger in a bold strategic move aimed at creating a formidable rival to Web search leader Google Inc (GOOG.O: Quote, Profile, Research).

Yahoo said the offer did not properly assess its audience of 500 million users worldwide, investments in its online advertising platform and its ability to generate cash.

The offer also does not take into account growth prospects or overseas holdings, which include a large minority stake in Yahoo Japan Corp (4689.T: Quote, Profile, Research), the company said. Yahoo said its board was evaluating all its strategic options

The decision by Yahoo's board and Microsoft's response sets the stage for another round of tit-for-tat exchange of words and posturing by the two tech giants that some analysts believe may yet draw in a third-party bidder. In seeking to fend off the takeover proposal, Yahoo could bring about a potential proxy battle if Microsoft decides to make an outright hostile attack.

The announcement initially pushed Yahoo shares up more than 2% at the opening bell as speculation heightened that Microsoft will raise its $31-a-share offer. Yahoo shares rose more than 2.2% to close at $29.87. Microsoft's stock, part of the Dow Jones Industrial Average, fell more than 1.2% to close at $28.21.