Does literature survey/review include relevant theory (from textbooks/old references) or should it only include recent publications? Should I place the theory as a separate chapter?
The age of theory really does not matter. If there is a relevant contribution from the 17th century that still matters today, then it is includable. It doesn't mean you should include it, but there is no reason at all to exclude it. Because of the pressure of "publish or perish," many current articles are of poor quality. Indeed, I just wrote to authors of an article because I felt they missed a very obvious explanation.
Conversely, there were fewer scholars the further you go back in time and they were often the pinnacle of the profession. While there was less knowledge to work with, there tended to be greater rigor. There are two important reasons to quote older works. The first is when the older work implies a broader range of options than the profession has taken or unintentionally foreclosed a path of research. The second is when an important element of prior theory is wrong. A quotation from a prior author can illustrate how incorrect thinking developed. For prior theory to be wrong, it has to make perfect sense as to how it is correct. The error has to be subtle.
Your literature review should include prior theory. The scope of that review should be deep enough and broad enough to cover the discussion of your research project. You should be aware of controversies that could impact you, the timing of that discussion is irrelevant. There is no virtue to an article written in 2017 and no reason to not quote older works, even including the ancient Greek mathematical writings. There are good reasons to quote Euclid's Elements.
If it is in print, ever, it can be used. Relevance is up to you and your advisor. As to whether it should be in a separate chapter, we can't really help you. You are writing a book. It needs to make sense. How can you best make sense.
There is a difference between previous empirical findings and theory. In my experience papers that pit these in separate sections tend to be a lot clearer.
However, conventions differ a lot between disciplines. I suspect that at some point in your study program the appropriate structure of a paper was discussed. Look at that again and stick to that format.
In many disciplines there's a strong tendency to prefer quoting more recent work. This has some legitimate reasons:
- New findings/developments even in the fundamental theoretical underpinnings of the field
- Modern restatements of fundamental theory which do not dwell on issues which are no longer relevant today (e.g. disputing the existence of the Ether and Phlogiston if you're a physicist)
but there are also motivations/reasons which I believe are inappropriate:
- "I quote the book/papers I was taught from" - people who don't bother to read original statements of theories to which they only read mentions elsewhere.
- Fashion: In Sociology I know that at some point, neo-Marxism was more popular and lots of people cited that, then post-Colonialism became all the rage etc. So you would see people quoting a bunch of articles and books from 10 years back or so, almost exclusively, as though that was the alpha and the omega of social theory. If I'm mixing up my examples then never mind, it's the principle that matters.
- Timidity in quoting non-academic / primary sources: Some people seem to have been inculcated with the notion that they're only supposed to quote from respectable academic work. Not so. Often better to quote a 19th-century rabble-rousing speech than the sedate and sometimes mis-representative article who mentioned it in passing a century later.
So don't shy from quoting any source which is materially relevant.
PS - Always provide detailed references of course, especially to sources which are potentially obscure. If the description of your source doesn't fit typical fields, don't hesitate to add a comment to your bibliography explaining what that source is and how to locate it.