It’s also true for Encore…if you add an AVI to the timeline (then you can put a chapter mark wherever you like, as long as it’s at least a half-second away from any other chapter marker- an MPEG-2 encoding limitation).
It will be smooth from menu to transition, then the laser will have to go to the timeline. On most DVD players, the last frame of the transition will hold until the timeline begins playing.
If you want to add audio fades or trim it, open the audio clip in an application such as Audition or PPro, then re-export the clip with the same name, and it will update in the Encore project.
2.7 GB sounds right for a 40 minute movie (it could be lower than that if you did your own bit budgeting and applied a custom preset). Encore compresses all video that is not already MPEG-2 to MPEG-2, which is required for DVD-Video playback.