Explanation

When a company aggressively capitalizes an expenditure rather than expensing it:

1. Accounting Impact:

   • Capitalization increases current period assets and equity (book value)
   • It reduces current period expenses, increasing current earnings
   • Future periods will have higher depreciation expenses, reducing future earnings

2. Residual Income Model Impact:

   • The residual income model values companies as: V₀ = B₀ + PV of future residual income
   • Aggressive capitalization artificially inflates current book value (B₀)
   • It also artificially inflates current earnings and ROE
   • This leads to an overstatement of the company's value in the model

3. Why Other Options are Incorrect:

   • Option A: Future earnings will actually DECREASE due to higher future depreciation
   • Option B: Current ROE will INCREASE because earnings are higher while equity is only slightly increased

The residual income model is sensitive to accounting choices that affect book value and earnings, making aggressive capitalization a concern for valuation accuracy.