Nizam.. you still owe me!

!!
Anyway what you ask is fairly simple
You do not need to convert the VCD to AVI as such
What you do is Explore the VCD
Then open the folder MPEGAV
This contains the actual video files . They are mpeg1 files
However you find them called AVSEQ 01, 02 ect with a filename extention *.dat
You need to rename them as *.mpg As such AVSEQ01.dat becomes AVSEQ01.mpg
If you cannot see the *. dat extention you need to change your file properties in Windows explorer
Like
THIS
Unless you rename them, they will not be visible to Vegas ( or any other video editing software for that matter,) as video files.
Once renamed as *.mpg, it then becomes a simple matter of importing them into Vegas File> import > media browse to where the newly renamed file is and edit them the usual way by dragging to timeline and trimming ect
You ,of course later output to mpeg2 for DVD.
As you are going from a smaller sized lower bitrate format (mpeg1) to a larger size file with bigger pixel dimensions and higher bitrate ( mpeg2), being in a DVD will not necessarily improve video quality which wasn't there in the first place
The joining video clips (or lack of) are down entirely to your own editing skills..
As for audio AC3 is a small size good to excellent quality audio which is perhaps just a bit lower on the Hi fi scale than PCM (CD audio quality but much larger size)
In practice ,the quality difference is not much if the AC3 is well encoded
Whether as Ac3 or PCM if the original audio is not up to scratch , which ever way you encode for DVD will not improve it