you mount the drive then copy the files from the image to your selfboot data directory. then you go to the data folder and delete the dummy file. then use selfboot tutorial to rebuild and burn the image.
Of course making an ISO isn't going to work, it doesn't contain the extra data tracks that the CDI images do, so it won't work.
But anyway, I think I read somewhere that the dummy files are only needed because CDs/GD-ROMs read faster from the outside than the inside, so the dummy file is used to push the real data to the outer edge of the CD/GD-ROM to speed up the reading of the data for the REAL DREAMCAST. It should not have any effect on Chankast.