If I were you, I'd rely on multi-channel MOD music files. ScreamTracker 3 (.s3m) would be easy to implement, and by supporting that you'd also be able to support 4-channel Amiga MODs with just a few code tweaks.
Here's a good start:
http://www.k9spud.com/traxmod/video-0.6.7.php
I'd switch the main CPU to an ARM7 as well. I don't think the Propeller for GPU is a bad choice, it all depends on how well you can take advantage of it.
I'd also use SD cards for game storage. They're cheap, big, and require MUCH less supporting hardware/power than a CD drive. If you ever want to make a portable version, the last thing you want is a huge disc drive.



