You'd definitely need to disconnect the changer--I have the iPodYourBMW interface in my 2005 325i and it uses the "CDC" mode on the headunit. "Discs" 1-5 are user-defined playlists, 6 is the full library.
I would double check BMW's website to verify compatibility. I think there were some running changes made to the Business CD headunit over the life of the E46; I believe the iPodYourBMW interface (which is made for BMW by Alpine, btw) only works on 2003-and later E46's (that's also what the Bavarian Autosport catalog is showing). If you want to retain the stock look, you could probably swap in a Business CD unit out of an 03-05; I have no idea what the compatibility would be between the newer headunit and your existing amp/speaker setup.
If you don't demand the "stock" look, Alpine makes some pretty good headunits that are iPod compatible.