The wheels are 27" so if you go with 700c the brakes may not work. 42-16 is fine for a gear ratio. You can get 27" alloy wheels. I had some SunCR18 rims with Formula hubs on a conversion.
The original wheels on the Raleigh are steel and so are heavy and the brakes don't work on them as well as on alloy rims. They will work, though. And the hub is a freewheel so you can spin the sprocket cluster off and put on a cog with a spacer. Might have to redish the wheel but that's no big deal. Should have the wheels checked out by a good mechanic to make sure they are properly tensioned and true.
If you are just trying to get rolling on the cheap, keep the wheels, convert the bike, then see how you like it.
http://sheldonbrown.com/singlespeed.html