Daemon Tools is a third-party application used to simulate CD/DVD drives. This virtual drive is used to run (mount) CD or DVD images you have stored on your hard disk. Common formats for CD/DVD images are .iso, .bin, .img or .nrg.
You can for example create images of your game CDs. For launching those games, you don't have to put the CD in the drive anymore, but you can mount the image with Daemon Tools.
MediaPortal has built-in support for Daemon Tools, which means it can automatically mount CD/DVD-images.