"We believe that a Yahoo sale to Microsoft -- at a price higher than the initial $31 [per share] bid -- is the most likely outcome," said analyst Mark Mahaney in a research note Monday.
[ Catch up on the entire Microsoft-Yahoo saga with Infoworld's special report ]
Yahoo's board of directors rejected Microsoft's initial offer saying it undervalued the company.
Mahaney added that the limited combined market share of the two companies would also allow the deal to get the thumbs up from governmental regulators.
Citigroup also raised its price target on Yahoo's stock to $34 from $31, saying that the new target price reflected its belief that Microsoft would increase its bid for the company.
"We think the strategic value of Yahoo to Microsoft is very significant," Mahaney said.
Mahaney said Microsoft is unlikely to walk away from the deal because it has yet to make significant inroads in the area of online advertising, especially against market leader Google, despite efforts to do so for the past three to four years. The only way Microsoft could compete with Google would be to acquire Yahoo, the analyst said.
Mahaney said Yahoo is aggressively pursuing other alternatives to Microsoft's unsolicited takeover bid, although he doesn't see any competing bidders for the company.
However, one possibility would be to tie up with Time Warner, whereby Time Warner would contribute its online content to Yahoo in exchange for a stake in the company, he said.
"We believe this could serve as a forcing function to a higher Microsoft bid," Mahaney said.
When contacted for comment, a Yahoo spokeswoman said, "Yahoo's board and management team are carefully evaluating all of the company's strategic alternatives and will pursue the best course of action to maximize long-term value for shareholders."
A Microsoft spokesman referred Computerworld to the company's press Web site for information on the deal.