I am currently setting up a HTPC. My reason is not for saving space though. The setup is definitely more difficult than setting up a conventional system, but once it's done, it is much more convenient to use.
I have my TV, video and recording functions through SageTV, Music and pictures through MC (my entire music collection) and it is all with quality equal to seperate components. I can also play games with this setup - add in my PS2 and I can play just about anything. It's all networked to my DSL router so that I can move stuff in and out of it, archive to optical disc or backup to a hard drive (RAID array eventually).
I have never been enthusiastic about the large CD changers that are available. Switching discs is slow and I have heard too many stories of damaged discs - not to mention that their capacity is limited and would still require adding and removing discs from time to time.
I can also use my HTPC to digitally archive my LPs and video and audio tapes. And to record music from Sirius Satellite Radio if I want to.
I can also access the internet from my living room via the network.
You are correct in saying that using a FM modulator will reduce the sound quality - it's a substantial reduction in fact. FM radio sounds good in the car, but in actuality it is really rather poor.
I just find the HTPC offers a ton more options and convenience than a traditional setup. I do still have a traditional CD/DVD player which I use for movies... I just find it easier.
Hope this helps...