The Apple TV and the Airport express both turn AAC into another format before it goes over the TOSLINK cable. What format is this? PCM? Maybe the Apple TV will just take 5.1 AAC and make it 5.1 PCM and the reciever will pick that up. Does it have to be encoded to AC3?
I'd like to address this since I have a trademark service agreement with Dolby Laboratories to use Dolby Digital logos/trademarks in conjunction with content I produce that meets their fidelity criteria...
Both AAC and AC-3 are perceptual coding schema. In fact, AAC is partially a descendant of AC-3, and was co-developed by Dolby Laboratories, Fraunhofer-IIS and a few other partners.
AAC supports multichannel audio, but it's not readable by an AC-3 decoder. In order for this to happen, the multichannel content must be transcoded.
There are hardware and software transcoders. One that strikes me as a distinct possibility for future AppleTV application is Dolby Digital Live. It was specifically designed to transcode multichannel output from, e.g., gaming platforms and other platforms that generate dynamically-changing multichannel audio (an operating system could be one example).
The advantage of this is that AppleTV as it is, is only a software upgrade away from incorporating such a transcoder.
The current bandwidth limitation of 160kbps for H.264-embedded AAC bitstreams are not really relevant to the question because that support too is essentially a software upgrade away. Less powerful processors have been used to decode DVD bitstreams in DVD players that range from 6 to 8 Mbps on a two-pass VBR encoded disc.
5.1-channel AC-3 is generally encoded into bitstreams ranging form 320 to 640kbps, with 448kbps being the fidelity standard for DVD and 320kbps being the standard bitstream encoded for theatrical application of Dolby Digital. Yes, you heard me correctly... Dolby Digital for DVD uses a higher bitrate than the theatrical variant.
It should be noted, however, that AAC's performance as a perceptual coding schema is superior to AC-3 at every bitrate. Put another way, an AAC bitstream would not need to be 448kbps to be perceptually transparent relative to AC-3.
At bitrates from 448kbps to 640kbps, AC-3 is perceptually transparent relative to an uncompressed multichannel stream. That is to say it's indiscernible from the uncompressed equivalent at those bitrates because of the way the encoding algorithm, low pass filtering, and other features reduce the bandwidth requirements for perceptible fidelity in the spectrum of human hearing.
A good reference measure is the performance of AC-3 stereo to AAC stereo. At 192kbps, 2.0-channel AC-3 is perceptually transparent. However, AES states that AAC is perceptually transparent at 128kbps.
The right transcoding algorithm combined with the right AAC parameters could, in principle, be capable of reconstructing a high-fidelity surround mix from 448kbps AAC or less. And this is not including any design improvements or new perceptual coding schema succesors to AAC.
In short, there's no fundamental hardware gap here... Just a software one.
Some will want to wait until that gap is bridged. Others, including myself, see this as an opportunity to support a very promising convergence of technologies that will drive the future of how we purchase, store, distribute, access, and experience home entertainment.
Any way you slice it, this technology is going to move forward and surpass the current fixed media schema. It was done with music recording (DAT is out, HDD is in), it's being done with digital cinematography (Thomson ViperStream, Panavision Genesis HD) and digital theatrical projection (Barco Cinema Projection HD, Texas Instruments DLP), and it continues with AppleTV and its inevitable emerging competitors.
The LAN is emerging as the backbone of home leisure/entertainment activity and all of Apple's efforts since 1997 have been sharply focused on broadening the original "hub" strategy from computer software/hardware integration with digital peripherals (iTunes, iMovie, iPhoto) to design and manufacture of digital peripherals (iPod) to datacenter distribution of content (iTunes Music Store) for digital peripherals to total household integration via the LAN and very soon WAN integration with digital peripherals (Mobile Mac).