Why is it not possible to do both merging and embedding? These are both two different approaches to do the same thing, which is to prevent you from having to ship the dependent DLLs. Doing both would not make sense.
The XAP could be bigger as a result because to workaround one of the strange issues in Silverlight, an additional manifest has to be added to the XAP. And if I'm not mistaken, the BAML resources are already compressed before SA gets hold of them?
I don't think the encryption key for strings and resources is stored in the assembly. Even it it was, I don't believe I would tell you where it is.