Jack - my reading of this is that they have sent you a CD for the purposes of applying for the specific opportunity, not for the purposes of recieving a general critique of their work. A polite and personal reply would be nice, thanking them for the CD (and maybe a nice word or two about it if merited), but explaining that they have not been selected for this year.
You shouldn't have to justify your decision. I don't think you are obliged to go into specifics - and a nicey-nicey formula sounds a bit patronising/impersonal.
Simplicity is usually best.

Kris