Well, I am not exactly sure what I just did but, I got it work. Downloaded another image file (which was in .dsk format) and then converted it over to DiskCopy 4.2 .img format, then wrote it, it booted up perfectly. How very odd.

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Always use Disk Copy 4.2 to handle the disk images in System 7.0 and up. But this is the key – never mount the newly created 400K disk under the Mac's Finder. Only insert the disk when Disk Copy asks for it, make sure verify and mount is not selected, so you insert the disk when prompted and the disk is spit out when copied. What happens is the 7.6+ Finder updates the database on the 400K desktop which can render it unbootable by an MFS system. You may want to look into directly transferring files out of your OS X Mac and vice-versa.