If you do not want to get a new CD or slipstream yours.
Leave the drive as 127 gig.
But after adding SP1 or SP2, you can go to drive management and Partiton and Format the remaining part of the drive as another drive letter. It will not be all one Drive this way but the space will be useable.
As far a using partiton magic to EXPAND the drive to take in all the 160GIG, well I tried it once and XP was very unstable. The drive was slow to access and sometimes things wouldn't work at all.
Completely started over with a slipstreamed disc with SP2 already in and it was fine.
If you are using a restore disk, you are in sad shape here. I have found that using an OEM version with your legal product key will work for a re-install.
You will have to provide the drivers etc. and it will not have all the bells and whistles that come with a HP or Compaq etc.
Some of us like that fact.
You could borrow an XP OEM disk with SP1 or SP2 already in it if you know someone who has one.
You could even make a copy. But use your own product key. It is legal to slipstream the service packs, even Microsoft tells you how.
You must still keep your original software CD and license.
This might be at the edge of what some would consider legal, but if your machine comes with XP home OEM from Dell or HP and you use a copy with your Product key, Microsoft should not complain about you doing this.
I have done it for others that could not locate a restore disk when they needed it.