1. Just get larger a 2.5" harddrive, it is not worth using an external 3.5" harddrive nowadays.
2. 4GB is the maximum, but you should make sure you have kickstart 37.350 and not 37.300 before you change harddrive as the latter usually is kinda quirky with many harddrives. Also, the maximum partition-size is 2GB.
3. Boot with the Install2.1 disk, repartition the harddrive with the HDToolBox partitioning-utility (found in the HDTools-drawer on the Install2.1 disk), reboot with the Install2.1 disk again, format the partitions that should pop up as uninitialized on the Workbench and then start the OS install from the "Install 2.1" drawer on the Install2.1 disk.
/Patrik