I think the problem is the CD ROM drive itself. It doesn't seem to run for some reason and it's not allowing the disc to boot.
That's a good possibility.
You held the C key down at start up to make it boot from the CD? Or hold the option key down till you see the blue screen and choose the CD as the startup disc.
You can get a slot loading CD player on ebay for less than $20 shipped, but if you want to experiment more I'd maybe recommend getting a different iMac. 400 Mhz or higher will have firewire ports, 500 Mhz or higher will have a better video chip that will help with OS X.
If you live in or near a major city there may be a computer recycler or used computer store that has iMacs for the same price as on ebay, or search ebay or graig's list for a local seller. I got a couple over a year ago for $65 each locally.
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