ROOT installed - is it ok to factory reset ?

You can factory reset. Granted you will lose all user data. So back up just user apps and data with Titanium Backup first. Do NOT back up system apps or data nor try to restore system apps or data otherwise you will have a mess on your hands. SU is on the internal SD and the internal SD is your root directory where you should save ROMs, kernels, modems, etc that you would flash from recovery. And honestly if you want smoothness you need to flash a custom ROM. Preferably a Captivate or I9000 based one that enables lagfix and runs on the ext4 file system rather than RFS (Robust File System, stock 2.2). Recommended ROMs would be Serendipity 6.4 or older Froyo based Apex. I don't recommend any Gingerbread based ROMs yet since you will have to learn and get comfortable flashing bootloaders first. Do some serious reading first before you keep asking general questions that are difficult to answer unless you know more about flashing. Point is stock Froyo on the Cap sucks and is quite laggy and no app will fix that unfortunately.  

Sent from my MIUI powered SGH-I897

If we upgraded the previous version of the phone then after storing it back to factory settings, will it roll back the version to the previous one.