If you set the player to native output of 720p, then the player will be doing all of the conversion, NOT your projector. That should eliminate your video noise problem, since it seems to stem from your projector not being good at upconversion. Also, I'd watch 720p over 1080i anyday. progressive scan will always give a smoother/cleaner picture when in motion compared to interlaced. Even if the interlaced image has more lines of resolution.
I'd highly reccomend upgrading to bluray. My tv is only 720p, but it's a 42 inch so it isn't quite big enough to really see the benefit of going to 1080p. And yes, good dvds do look better (though I wouldn't go so far as to say they look as good, or almost as good as a well done bluray). But I doubt you'll have the urge to upgrade your whole collection. I'm a nut about video quality & I don't have that urge. Sure, there are certain titles that I have, or plan on upgrading b/c I think the difference is worth it. but it's really only a small fraction of movies. The Gamera Trilogy is actually a really good example of something I upgraded. The blus look SO much better than the dvds (although we're still waiting for the release of GIII) and the price was just too good not to upgrade!.
Close Encounters of the Third Kind is another GREAT example of a title totally worth upgrading. The transfer is just phenominal AND it comes with all three versions of the film for the first time (the original theatrical, the special edition theatrical re-release, and the final directors cut, which was the only version previously released on dvd). It also has tons of bonus features that are actually interesting and can be found for pretty darn cheap to boot.