You have the option to choose which disk to initialize, or to put that a bit better, to change the drive that is targeted by the drive setup software. Click on the 'drive' icon (as I recall) before you click 'initialize' and the software will search for all available drives, and allow you to choose which is the target. As has been said, you'll want to initialize the internal HD (assuming that it is still working well enough for HD Setup to find it, or in this case, assuming it (a) is properly terminated, and ( B) that it has Apple Roms - but that's another story, so let's assume for the moment that it is and that it does have them).

The fact that you managed to boot from the cd means that the machine is otherwise sound, by the way, so that is a good sign; the only remaining question concerns the hard drive. Once you start the initialization process, and the little wheel begins to spin, just let the software finish its task and all should (touch wood) be well, with a mounted internal hard drive on which it will then be possible to install the system.