Line a large baking sheet with paper towels. Set aside.
In a large pot, begin heating about 2 inches of oil, over medium heat, until the temperature reaches 375 degrees.
Meanwhile, in a medium-size saucepan, set on a medium-heat burner, stir together the milk, water, butter, 3 teaspoons sugar, salt and vanilla. Continue stirring the mixture, cooking it until it comes to a boil (this should take just a few minutes).
Remove from the heat and use a spatula to immediately fold in the flour and baking powder. Continue folding until everything has combined into a ball.
Transfer the dough to a pastry bag fitted with a large star tip. Pipe 4-5 inch pieces directly into the hot oil, cooking only 3-4 churros at a time.
Use tongs to turn the churros until all sides are golden brown, which should take about 2-3 minutes. Remove to the paper towel lined baking sheet and repeat until all batter has been used up.
In a large bowl, combine the remaining ½ cup of sugar with the cinnamon, then toss the churros in this mixture.
To make the sauce, combine the chocolate, cream, tequila and chili powder in a small saucepan set over low heat. Stir constantly until the chocolate has melted and the mixture is smooth.
Serve the sauce warm (it can be made ahead and easily reheated in the microwave).