Every external drive I've bought has got the same kind of 3.5" or 2.5" hard drive as is fitted internally to the desktop or laptop computers that I have bought. Internal is best if you have the room but a locally connected external works fine. A backup is vital. All drives will fail eventually, often without warning. The key factor is large. If the library is large enough not to fit on what is inside your box then it needs to go outside. A split library with media on NAS storage is a possibility, but iTunes doesn't play well with NAS and transfer rates are generally lower than with a local drive. RAID is great for those with the budget for it.
Let's try to explain the terms.
Keep organized controls what happens to files that are located inside the media folder when they are added to the library or if you make a change to their metadata after they have been added to the library. If the option is enabled the folder and file names may be edited to reflect the content of the tag, with music typically going to <Media Folder>\Music\<Album Artist>\## <Name>.<Ext> otherwise the file stays where it was. (There may be an optional leading disc number if the disc number or disc count is greater than 1, Artist is used if Album Artist is blank, and there is also an iTunes specific compilation flag that can put tracks in <Media Folder>\Music\Compilations<Album>.)
Copy files controls what happens to files that are outside the media folder when they are added to the library. If it is enabled iTunes makes a new copy inside the media folder based on the tag properties. It doesn't "remember" that the original has been imported so you are at risk of making duplicates if you import the same folder again. If the option is disabled iTunes connects to the file on its original path, the file's tag will be updated if you edit properties, but the file won't move.
Consolidate files tells iTunes to import files that are currently outside of the media folder in the same way that it would if they were added when Copy files was active. In and of itself consolidate files doesn't create duplicates within the iTunes library, but there is the potential for you to reimport the original files later unless these are actively archived or deleted after consolidating.
Anything ripped from CD, downloaded from the iTunes Store, converted to a new format, or added using the Automatically Add to iTunes folder is moved into the standard folder structure whether or not Keep organized or Copy files are enabled. A typical use case for Automatically Add to iTunes would be if you had a drive with media brought over from another computer that you want to add to iTunes. You can either add the folder when Copy files is active, or copy the folder of media into Automatically Add to iTunes. You shouldn't ever need to use the folder as part of moving an existing library from one computer to another. An advantage of using the folder will be that anything that iTunes cannot handle will be moved into a folder called Not Added. if you just add the folder in the normal way iTunes will silently ignore any track it doesn't like but you will be none the wiser.
Changing the media folder location tells iTunes where new media will be stored. When you make the change iTunes will typically offer to consolidate files to the new location, but you don't have to let it do so. If you want to change which library is opened you need to hold down shift (Windows) or atl/option (Mac) as you launch iTunes and then use the options to choose a library or create a new one.
Apple don't refer to the library folder as such, but it is the folder that contains the library database file, normally called iTunes Library.itl, along with some supporting files, the Album Artwork cache folder and, typically, the media folder iTunes Media. When all content connected to the library is inside the media folder, and the media folder is directly inside the library folder, then the library is in a portable shape that can be easily moved from one computer, drive, or path to another with out breaking the links between the library and the media. More at Make a split library portable.
Files in .wav format do not carry a tag. Windows Explorer shows no additional information for them. iTunes will import these to the Unknown Artist\Unknown Album folder. If they are still on paths that reflect Artist and Album after they are added to the library (which will depend on original location, media folder location and choices for Keep & Copy) then I have a script that will read in the data from the path: TagFromFilename. If cannot help if the files have been moved into Unknown Artist\Unknown Album unless there is an alternate undamaged source.
Occasionally .mp3 files have multiple tags with inconsistent information. It isn't clear which one iTunes will give preference to.
iTunes cannot play .wma files natively, but it can transcode them on import. If you let it do so the original are left untouched and it is the new copies that are added to the library in the standard place as determined by the tag data. You may choose the file type and bit rate from those that are available for the new copies. You are not limited to AAC. Then is no point changing from one lossy codec to a higher quality alternative since you get bigger files with no actual improvement in quality.
iTunes doesn't actively monitor the media folder (apart from Automatically Add to iTunes) so if anything else (such as Windows Media Player) moves files around this can break iTunes link to the track. If files have been deleted from iTunes, or simply placed in the media folder without adding them to iTunes, then iTunes won't see them. However if a new version of file is added to the library that should be stored in the same place as a file that already exists iTunes will make a new file but add a trailing " 2" or " 3" to the filename rather than pick up the existing file.
With respect to duplicates iTunes is sensitive to where the file is located with respect to the media folder and the options for Keep & Copy when it is added. If you repeatedly import content located outside of the media folder when copy files is active, or subsequently consolidate files and reimport, you are instructing iTunes to make duplicates. It isn't smart enough to know better. Importing existing playlists when the imported files may be copied or moved as a result of the import can also lead to problems. This may well be why some people get duplicates when importing the media folder on a new computer and they have only copied over the media folder rather than a complete working portable library.
Occasionally iTunes will put files in odd locations such as the desktop or the root of the C:\ drive if there are permissions problems with the folders where it wants to put things. See Repair security permissions for iTunes for Windows for a fix if needed.
I assume that hexadecimal encrypted folders refers to the arrangement of folders and files within the Album Artwork folder. This is an artwork cache and is required for the normal operation of iTunes. If you mean something else please say.
Now for some boilerplate....
Apple's official advice on duplicates is here: Find and remove duplicate items in your iTunes library. It is a manual process and the article fails to explain some of the potential pitfalls such as lost ratings and playlist membership, or that sometimes the same file can be represented by multiple entries in the library and that deleting one and recycling the file will break any others.
Use Shift > View > Show Exact Duplicate Items to display duplicates as this is normally a more useful selection. You need to manually select all but one of each group to remove. Sorting the list by Date Added may make it easier to select the appropriate tracks, however this works best when performed immediately after the dupes have been created. If you have multiple entries in iTunes connected to the same file on the hard drive then don't send to the recycle bin.
Use my DeDuper script (Windows only) if you're not sure, don't want to do it by hand, or want to preserve ratings, play counts and playlist membership. See this thread for background, this post for detailed instructions, and please take note of the warning to backup your library before deduping.
(If you don't see the menu bar press ALT to show it temporarily or CTRL+B to keep it displayed.)
The most recent version of the script can tidy dead links as long as there is at least one live duplicate to merge stats and playlist membership to, and should cope sensibly when the same file has been added via multiple paths.
tt2