How should I set the settings for capturing analogue ? Should I capture it in AVI format first then encode it to MPEG2? Should I set the TV System to PAL or NTSC? Sorry for all the questions, Im new to this and want the best quality that is possible with the software I have.

The PAL or NTSC will depend on where you are. It's different in in some countries to others. If you are in UK choose PAL, or for USA choose NTSC. Anywhere else, look on google if you're not sure.
If you want to edit the capture and have the disc space, go for AVI, edit and then encode to MPEG.
Experiment with a short clip of 5 mins or so with each, ie. AVI then encode and again with direct to MPEG and see if there is a difference.
I am assuming you are going to make a DVD from the videos by the way. I hope this helps get you started.

Thanks for the replies, I am going to make a dvd out of it. If I dont have to capture to AVi I wont, I will just encode it as I capture it to MPEG.