Ah thanks everyone. Found that I was missing the xvid codec from my system. Downloaded it and it now adds the avi file as it should.
BUT, the full movie (750Mb in size) takes over 80 hours to convert to MPEG-2.

I changed the settings of the software according to the suggestions from the dvdrhelp site. 80 hours! Yikes! So TMPGenc doesn't like xvids. I'll have to test the pther software out. Are they fairly straight-forward? Or requires a lot of tinkering like the TMPGenc?
My system specs:
Pentium III - 750 Mhz
768 MB RAM