| The car should be able to run on unleaded gas. I can't see how that should be your problem. Maybe it just needs the valves adjusted with regards to the valvetrain noise?
Now, as to the idle, I have two ideas, though I'm not sure they apply to the M40 engine. On my '85 325e I have a very similar erratic idle problem, and I've traced it to one of two things, both of which will be replaced when I get the money. Does you engine have an idle control valve? If it does, get it cleaned, or if i hasn't been done before, replaced. That might help. What I've also been told is that the MAF sensor (mass air flow) can cause this. When you hooked up your K&N, you left in the air flow sensor assembly and added the K&N intake to the end of that, right? If not, that could be your problem.
Those are my two shots at it. Hope they help.
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Changed the car's name, now it's - Roxanne -1985 325e | 
