Updated from 1 p.m.

Yahoo!

(YHOO)

rose 3% Friday after a Wall Street analyst fingered the struggling Internet stock as a prime takeout play.

Microsoft

(MSFT) - Get Report

should buy Yahoo! to give its struggling MSN Web unit a much-needed boost, according to a report issued by Merrill Lynch analyst Justin Post. Microsoft and Yahoo! declined to comment on the Merrill report.

Yahoo!, whose shares have declined more than 20% this year, currently has a market valuation of $43.9 billion. Microsoft could buy the Sunnyvale, Calif.-based company with $20 billion in cash with the remainder in debt, according to Post's analysis.

Merrill says the deal could trim Microsoft earnings next year by 5 cents a share. Analysts expect the software giant to make $1.40 a share in fiscal 2007.

Post arrives at the possible EPS hit by noting that the acquisition would reduce Microsoft's cash hoard, cutting its interest income. Issuing debt would boost interest expense. "The higher the price Microsoft has to pay the the acquisition, the more debt and interest expense necessary," he notes in an email.

Merrill has done non-investment-banking work for Microsoft in the past 12 months and expects to receive investment-banking work from the software company. It has neutral ratings on Microsoft and Yahoo!.

Buying Yahoo! might not be popular with Microsoft shareholders, who have criticized the Redmond, Wash.-based company for holding $34 billion in cash on its balance sheet. They also are angered by Microsoft's plans to spend as much as $2 billion to catch up to

Google

(GOOG) - Get Report

in search.

"Even though Yahoo! and Google are competing for the Internet advertising dollar, Google is doing more by building software, and Yahoo! is doing it more by aggregating content," says Tony Ursillo, a software analyst with Loomis Sayles, which owns shares of Microsoft and Yahoo!. "Microsoft's focus is on building software, not aggregating content. I don't think it would be consistent with Microsoft's approach."

Still, Post says the case for the acquisition, which has been rumored before, is more compelling than a Microsoft purchase of

eBay

(EBAY) - Get Report

.

"An acquisition could instantly vault Microsoft to the leading revenue position on the Internet," writes Post, who joined Merrill in 2004 from Deutsche Bank.

Post estimates that merging Yahoo! with Microsoft's MSN business would create $450 million in savings. He is forecasting that that MSN, which has recently introduced improvements to its advertising platform, will lose $800 million next year.

"A potential acquisition would significantly accelerate Microsoft's efforts in search," Post writes, adding that a deal would "build on both brands and extend Yahoo!'s lead in Internet traffic."

Selling such a deal to Wall Street could be tough.

Microsoft shares have dropped 12% this year, underperforming the

Nasdaq Composite

Index, which has declined 4%.

In addition, investors have high hopes that Yahoo! will improve its position in the search market and continue to benefit from the shift of advertising dollars online.

Plus, Ursillo and Post point out that Microsoft would face an exodus of key employees at Yahoo! if it bought the top Web site. Yahoo! executives have made similar arguments, and Post writes that he doesn't think that Yahoo! co-founders Jerry Yang and David Filo are interested in selling to Microsoft.

Shares of Microsoft fell 13 cents to $22.75, while Yahoo! rose 51 cents to $31.19.