I currently have my own arcade conversion going. It was originally a sega 2b cab, but now it's being converted into a Mortal Kombat cabinet. I'm using an xbox to emulate all mortal kombats.
Purchasing those x-arcade or kb/mouse converters is fine and all. Personally I went with the guts of mas system sticks for mine but I wanted multiable systems. But what I've found to be the cheapest method is cheap xbox arcade controllers. They're basically a plastic version of real arcade controls so the boards in them can be wired in easily to work with real arcade buttons and switches. 20 bucks and you have your acade controllers working on your xbox.
as far as hd's go in xboxes, now a days you can install as big as IDE goes. I've done 300gb hd's in xbox, I suggest 250gb 7200rpm 8meg cache, can usually find those for a reasonable price (scored one for 140 recently). HD switches are rad though (900gb xbox mmm) (does boot from f still protect you for live, or do you have to use a retail hd now?)
Soft mods suck, but using soft mods to do tsop flashes are always nice.
Have fun, enjoy, get pictures up!