Hi Dave,
Web.config is a standard ASP.NET file - hence why the instructions don't specify it should or shouldn't be a file.
Your URL should work for both your computer name and localhost, "mysite" is just a way of saying replace with your site's server name in the documentation, so using it verbatim probably won't work unless your domain/server is called mysite.
As for SQL - if you have MS SQL installed already - you don't need to install it again you can just set the database up in that instance, provided it's SQL server 2005 (any edition). Your settings would probably be server name: localhost and repository: - whatever you want to call it, this will be the name of the database that you want to create on the SQL server to hold your content repository, but before you go ahead and do that...
From a number of things you say here, I'm coming to the realisation that perhaps you're not familiar with .NET, ASP.NET, IIS, SQL Server or development in general? To be honest if that's the case I would recommend buying a book or two covering these topics and getting to grips with the basics before trying to work with a reasonably complex product like Flux as you are expected to have a good understanding of .NET web development to write the templates and so on, it's not really a tool for novices, and if you want to do anything more complex like extend Flux, you really do need to have a solid understanding of web development, SQL development and the .NET framework.
Cheers,
Tony