That seems like a nice projector, 120" is a pretty large image and yet your 1.83GHz Core 2 Duo Mac, these days, is a pretty poor Mac for HTPC. The crappy GMA950 underwhelmed when it was released, I lived with a 2.0 C2D w/ the GMA950 for a while so I know, but that was 5 years ago, now? So, my advice right off the bat is fight your excitement, don't spend too much on upgrading just yet because you may realize that Mini is not going to work out for you long term. By all means, set it up, start figuring some things out, just don't invest much because you may be much better off selling that model, taking the proceeds of that sale and putting it toward a 2011-2012 model, which will suit you in the long term much better.
I've upgraded to Snow Leopard. It's too old for Mountain Lion, but if I upgrade to 2+GB of RAM I'll be able to install Lion
Do max the RAM, that model (I think) can see 3GB of RAM, which again, isn't all that much. Stay at SL for a while, don't be in too much of a hurry to go to Lion. SL with XBMC got to be a very stable very good home theater OS. Lion won't improve the "home theater" performance of that machine, so don't upgrade just to upgrade.
The video side of this is simple enough...
Rarely is the video side simple enough, though you're right, what you're planning should work. Best to avoid USB for audio as well, USB typically can't pass DTS or DD 5.1, but that mini-jack on your Mini is also
optical, so just use an optical cable with an adapter tip and you'll be all set with digital surround to your AVR.
if there's some way to merge the audio signal into the video and have it all end up going into the receiver over HDMI, that'd be sweet
Keep things simple and straightforward for now. There are ways but the added expense usually isn't worth it, plus those devices are fraught with bugs and poor user feedback, whereas running optical separately to your AVR will work just fine. Here's another area where you do not want to throw good money after bad, spend as little as possible while you're experimenting because you might realize you want to step up to a more powerful Mini and when you do it will come with HDMI built-in, and then you'll be stuck with a crappy DVI and optical into HDMI converter that you don't need anymore. Buy that Apple TV instead of spending anything on this, and frankly, for your needs, the Apple TV is exactly what you need since you're only interested in iTunes and perhaps Netflix. You're an ideal Apple TV owner.
Is there a good input device out there for Mac HTPCs
I use an iPad with various remote control or screen sharing apps depending on what I want to do. I also suspect you're not going to enjoy surfing the web or doing general computing much looking up at a 120" wall with a keyboard in your lap. But by all means, do it and see for yourself. I've had the Apple BT keyboard for years and rarely used it on the couch in a home theater context. There have been tons of threads over the years about how to control your Mac, so just look back.
Where else do you get your content?
CDs, DVDs, Blurays, and recording TV content over cable. The only time I ever put a physical disc in a drive is to rip it. I don't get much content from iTunes, over the years I may have rented a grand total of a few hours of movies and TV and only bought a handful of albums.