Hi Jim - if you're planning to convert the images to greyscale for the MOBI version, because the Kindle only displays greyscale, I'd recommend not doing so. The "Kindle for..." applications (Kindle for PC, Kindle for iPad, etc) all display colour images, and it would be a shame to lose that facility. Also you never know - there might be a colour display Kindle just round the corner.
I took a copy of your EPUB file, and converted it to MOBI format using Amazon's Kindlegen application, without changing anything in the EPUB file, and a. it converted fine, without any problems, and b. the images look fine on the Kindle 3. I've attached some screenshots from my Kindle so you can see what it looks like. (Note that I don't think I've got the text settings on the default settings - my current settings have slightly larger text and more space between lines of text.)
One thing I noticed, though - there seem to be some inconsistencies in the type of single and double quote marks used - sometimes curly, sometimes straight. I've highlighted that on the fourth screenshot here. You might want to go through the EPUB file and fix that before you publish, and before you create the MOBI version.
When you come to create the Kindle version, I'd highly recommend using Kindlegen to convert the EPUB to MOBI format. You can then simply upload the resulting MOBI file on the Kindle Direct Publishing
website. If you don't have a Kindle to check it on beforehand, you can use the Kindle Previewer application - gives a pretty accurate simulation of what an ebook will look like on Kindle, Kindle DX, Kindle for iPad and Kindle for iPhone.
Kindlegen and Kindle Previewer can be downloaded free from http://www.amazon.com/gp/feature.htm...cId=1000234621