A little unexpected but I think this was the right decision for Microsoft for a couple of reasons:

1. Jerry Yang was doing everything in his power to prevent MS from acquiring Yahoo - what type of message does that send and how must the employees of Yahoo feel if their CEO is acting this way.
2. In order to compete with Google, the merger must have gotten done quickly and smoothly, this would not have been the case in the case of a hostile takeover.
3. There have been rumors that many of Yahoo’s employees were just waiting for the merger to happen in order to cash in on their new accelerated vesting and compensation packages, immediately leaving Yahoo there after.
4. A lot of the Yahoo employees and MSFT employees and investors did not want the merger to go through. From what I know the largest group that wanted the merger to go through were the Yahoo investors, albeit at a higher price.
5. Yahoo will now have to deal with a variety of problems: shareholder lawsuits, talk of Jerry’s management ability, sudden price drop. All these may in fact lead to another Microsoft offer in maybe a few months at a much lower price - in which case it will probably be accepted.

The only downside that just immediately to my mind is that MS and Yahoo are in deep water and do need to do something in order to compete with Google - but I do not think the merger would have necessarily helped them, given the merging difficulties and the corporate culture clash.