Edit: This is in Dragon's Lair 2!
The butterfly can be found in the Beethoven musical section (After Eden, before Egypt). After flying into the air on Beethoven's piano there will be a couple sections where the cat will breathe fire at you. The butterfly will cross the bottom (sometimes the game mirrors scenes so it'll be from the left OR
the right, dependent) of the screen *in* the fire and end up in the cat's mouth.
You must hit the left or the right, depending on screen direction to grab the butterfly. I managed to grab it just as it was entering the cat's mouth!
Unfortunately this is about the best shot I could get of it, it's pretty hard to see and I was only able to find where it was by watching the game in the extras a couple of times.