Release the Bootdisk image (Click on it this time).
VirtualPC console should automatically revert to the Physical drive, but if it doesn't you may need to manually select this option from the CD menu.
Restart the VM, Don't get too excited about the splash screen...
You should now be at a C:\> prompt with a CD drive R.
Insert your Windows 95 CD in your physical CD-Rom drive. Navigate to the R: drive and start Win95 Setup
Ensure you tick the hardware detection options
Do not create a startup disk
Setup will prompt you to restart