By PETER LAURIA and ZACHERY KOUWE

February 10, 2008 -- An up-against-the-ropes Jerry Yang and Yahoo! have rejected Microsoft's unsolicited $31-a-share offer and are expected to break the news to the software behemoth tomorrow, according to a source close to the situation.

The Yahoo! board, which met Friday, feels the $44.6 billion bid "massively undervalues" the search titan, the sources added, and will spell that out in tomorrow's letter.

A Yahoo! spokesman would not comment on Microsoft's offer, saying only the company is "pursuing all options."

While the surprise Feb. 1 offer was a 62 percent premium over Yahoo!'s closing stock close the previous day, it is below Yahoo!'s 52-week high of $34.08. The Post reported last spring that Microsoft offered to buy Yahoo! for $36 a share but then-CEO Terry Semel rejected that overture.

The Yahoo! board is concerned, too, that the $31 offer doesn't account for the risks the company would take by jumping into bed with Microsoft CEO Steve Ballmer as regulators might overturn the deal, this source said.

While a Microsoft-Yahoo! combo would still trail industry leader Google in terms of the size and power of its search-advertising business, the Micro-hoo duo would be the largest operator of e-mail and instant messaging and could raise enough antitrust concerns in Europe to scuttle the deal.

It is believed that Yahoo! CEO Yang would still fight for a price higher than $36 a share. There has been speculation that Yahoo! would not accept anything less than $40. That would be a premium of roughly 17 percent over Yahoo!'s 52-week high - but would cost Ballmer an extra $12 billion.

It is not known whether Ballmer would give approval to upping the Microsoft offer. But one source said Capital Research, whose 6 percent stake in Microsoft ranks it as one of the largest institutional shareholders, might have some problems with it.

Capital Research also ranks as Yahoo!'s largest shareholder, with an 11 percent stake, and sources said the firm is concerned about losing more money on its Microsoft stake than it would make on its investment in Yahoo!.

In addition to weighing a richer offer, Ballmer must also chew over the option of "going hostile" in an attempt to win over Yahoo! shareholders. While the hostile route - which includes taking the offer directly to each and every shareholder - has its downside, Ballmer is a bulldog and has indicated he is not afraid of a bare-knuckle brawl. When Microsoft decides on a particular path to pursue, the CEO has said: "We keep on coming and coming and coming and coming."

Yang and his Yahoo! board have been scrambling the past nine days to find alternatives to the Microsoft bid. The Post reported yesterday that Yang reached out to Time Warner to explore options between AOL and Yahoo! Nothing came of the call.

peter.lauria@nypost.com