I really like the W123 better over the W124 and being a W123 owner for several years, I'd like to stay in that road...

Perhaps a Ford diff might be a good option, but if some customization has to be done, I rather use a Mercedes diff to stay on the purist side. Perhaps a W126 diff with the proper gear ratio such a 3.46, which gives you excellent off-the-line performance while limiting the top speed a bit to stay within the W123 speed capabilities. IMHO.

Regarding the interference with the inner fenders, I've come to several wonderings on this subject. I've read that the M116 is a narrow V8 and it is full 2" narrower than the M117. It was available in 3.5, 3.8 and 4.2 liters, while the M117 was available in 4.5, 5.0 and 5.6 liters. Some of the early M116 were cast iron, while the later model are alloy. Also, both the M116 and the M117 share a lot of internal, such as conn rods, bearings, fuel injection system, etc. Being the M116 narrower and presumably more convenient for this project, would it be possible to fit larger pistons to increase the displacement to brind it on par to the M117? That would provide the best of both worlds: higher output in a smaller package... Just brainstorming...

__________________
1982 W123 300D NA Euro, 300K Miles, 4-speed manual, 3.46 rear diff, early W126 front brakes, Penta rims with 205/60R15 FH900's, custom fitted (by me) audio system, more to come into the money pit... Soon to be installed: Bilstein HD, R107 front discs and 4-piston calipers, HD Suspension springs, wagon front swaybar.