You must boot from the CD. But remember to set the CD drive as the first boot drive in BIOS. Hope you know that. After it starts the POST, you may have to press any key for CD booting.
After the first CD boot, you will get the various options including formating and choosing between FAT32 or NTFS.
In my opinion, NTFS is a bettter file system overall with XP. Before XP is completely setup, it will reboot several times. Ensure it doesn't boot from the CD a second time or you will go in a circle and start at the beginning everytime. After the first CD boot, the very next time it restarts, set the hard drive as first boot device in BIOS.
Hope this is clear.