Simple answers to your simple questions:
Yes, you can just format C: and install the new windows version there. And yes, you'll be able to access the files on D and E. And you're right about not being able to run programs installed with the old OS.
But: What if something goes wrong and you end up formatting the entire hard disk instead of just C:?
So yes, rather get another hard drive and install windows there. Unplug the old drive during the installation just in case. Re-plug it. You should be able to do the installing with the old drive connected, but you may end in the situation I'm in after following the instructions referred by Chalenge: The XP disk won't boot any more. I still can access all of the files in it, though, so nothing got lost.
Or you can save the files you want to keep elsewhere and start off fresh.
Depending on your budget, I'd suggest the last two alternatives. Dual boot would also work, but honestly you'd soon be using the new OS only. When I did that to a customer, there was some trick to be done in order to be able to save some settings, can't remember what it was any more...