As you know, standard DVDs will be 480P straight from the disc but your projector will display a 720p image. Converting the 480p signal up to a 720p signal can be done by either the xbox 360 or the projector.
You have two options.
1 - Set the Xbox 360 to output 480p. If the Xbox 360 outputs 480p, the projector will convert (upscale) that 480p signal to 720p.
2 - Set the Xbox 360 to output 720p. In this case the Xbox 360 will take the 480p signal and upscale it to 720p to output. This 720p signal will then be displayed by your projector.
Which method you use depends on whether the Xbox 360 or the projector does a better job of upscaling. This is purely a subjective call, and in most cases the differences won't be noticeable unless you are specifically looking for them.
To answer your question - There is no right or wrong way to set it up. Try them both and see which one you like better.
And fyi - this is probably better suited for the Xbox forum, or even the DVD player forum.