Because of the CD installation, I am going to take a wild stab here. Recently had the same error message installing my son's new Scooby Doo software and didn't have time to run it down. When I saw your question I subscribed to see what came up. Since then I checked out the faq's for scooby doo support. Nothing. Then I searched their web site for 'Setup.exe and win32' and got this http://www.riverdeep.net/support/faqs/l/lrntspkngl1120.jhtml
They blame a similar message with their software on "CD-ROM drive is incapable of opening enough files from the CD-ROM to install the program. This generally occurs on only one model of CD-ROM drive made by Matsushita". They also reference Win95 but my problem popped up in Win 98 and I do
have a Matsushita drive.
I tried to drill down on this in the MS knowledge base but couldn't find anything fast. There are many hits on the 'not a valid win32 application'. Most deal with their products, but the jist of it is that there are things outside of LV that can cause this error message.
I would try to install the software from your hard drive first and see what happens.
If it installs ok then http://support.microsoft.com/default.aspx?scid=kb;en-us;Q218617 (How to Troubleshoot CD-ROM or DVD-ROM Read Issues (Q218617)) might be a good place to start.
Rahts of Ruck, Shaggy!