More than likely diskspace but in retrospect it seems like they made a lot of mistakes when developing this. I mean even at their base resolution the backgrounds look much worse than the originals must have. Also pictures don't take up THAT much disk space they could have decided to not downsize the images since most monitors were bigger than those background image sizes anyway. Idk I just feel that this game lost a lot of its graphic and audio potential in the packaging process.
No, the backgrounds were IDENTICAL to the PSX version. They only look worse because of the differences between the way a PC monitor and a CRT television display images.
WAV is uncompressed, so I think it would have taken a huge amount of disc space. It's just a pity that the psf format couldn't have been ported over to the PC version, since it allows quality close to mp3s but file sizes more reminiscent of MIDIs :'(
I know little of PC hardware from back then, so I can't say whether WAV music would have made the game harder to run; I don't imagine it would have made it any easier to run...
Pretty much any PC capable of playing this game could handle either WAV or MIDI music, no problem. PSF, not so easily. While it's very lightweight by today's standards, it's rather processor-intensive by 1998 standards, especially given that the first usable version of Neill Corlett's PSF plugin for Winamp wasn't even released until 2002 and wasn't nearly as optimized as current versions. Combine this with the fact that FFVII-PC already doesn't run at full speed on computers that meet-but-don't-exceed the system requirements, it would have been a disaster. Even MP3s were too taxing to use, they had to use an audio format that could be completely handled by the soundcard, without help from the processor (WAV and MIDI both fit this requirement).
As for WAV, the disc space pretty much sums it up. You couldn't fit all the songs in the game in uncompressed WAV format at a decent quality on one CD, as evidenced by the fact that the soundtrack took four (CD-audio is virtually identical to uncompressed WAV). Even if you cut out songs that are only used in specific discs, similar to the FMVs, you couldn't fit all the music, especially alongside game data and FMVs. The only way to manage it would be to significantly lower the audio quality to 8KHz or so, at which point the music would sound significantly worse than the MIDIs, more akin to AM-radio.