handbrake can preserve all your audio tracks and subtitle tracks from your DVD. if the only subtitles are the old-fashioned bitmap titles, I convert them to text before including them in the MKV so that I have nice sharp vector text. mkvmergeGUI is a great for manipulating the contents of a MKV file.
but the question remains whether you can play video files off of an external hard drive on the Xbox and I'm pretty sure the answer is no now since if you plug it in, it'll want to format it and set it to 16GB no matter how big the drive. If you want to stream your movies to the Xbox, no problem if you go with a wired connection to your network. and since he hasn't made his DVD movies yet, he can choose a format that works best for the Xbox. If the Xbox and PC are the playback devices, making WMV would be the best. If he needs to play on other devices, then sticking to H.264 or MPEG4 is needed.
http://support.xbox.com/en-US/xbox-360/settings-and-initial-setup/watch-dvds-movies
AVI support
The Xbox 360 console supports the following for AVI:
File extensions: .avi, .divx
Containers: AVI
Video profiles: MPEG-4 Part 2 (Simple Profile and Advanced Simple Profile)
Video bit rate: 5 Mbps with resolutions of 1280 × 720 at 30 fps
Audio profiles: Dolby® Digital (2 channel and 5.1 channel), MP3
Audio max bit rate: No restrictions
H.264 support
The Xbox 360 console supports the following for H.264:
File extensions: .mp4, .m4v, mp4v, .mov, .avi
Containers: MPEG-4, QuickTime
Video profiles: Baseline, main and high (up to level 4.1)
Video bit rate: 10 Mbps with resolutions of 1920 × 1080 at 30 fps
Audio profiles: AAC, 2-channel, Low Complexity
Audio max bit rate: No restrictions
MPEG-4 Part 2 support
The Xbox 360 console supports the following for MPEG-4:
File extensions: .mp4, .m4v, .mp4v, .mov, .avi
Containers: MPEG-4, QuickTime
Video profiles: MPEG-4 Part 2 (Simple Profile and Advanced Simple Profile)
Video bit rate: 5 Mbps with resolutions of 1280 × 720 at 30 fps
Audio profiles: AAC, 2-channel, Low Complexity
Audio max bit rate: No restrictions
WMV (VC-1) support
The Xbox 360 console supports the following for WMV:
File extensions: .wmv
Containers: ASF
Video profiles: WMV7 (WMV1), WMV8 (WMV2), WMV9 (WMV3), VC-1 (WVC1 or WMVA) in simple, main and advanced up to level 3
Video bit rate: 15 Mbps with resolutions of 1920 × 1080 at 30 fps
Audio profiles: WMA7/8, WMA9 Pro (stereo and 5.1), WMA Lossless
Audio max bit rate: No restrictions