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The embryonic urogenital sinus mesenchyme (UGM) induces prostate epithelial morphogenesis in development. The molecular signals that drive UGM-mediated prostatic induction have not been defined. We hypothesized that the TGF-beta signaling directed the prostatic induction. UGM from TGF-beta type II receptor stromal conditional knockout mice (Tgfbr2(fspKO)) or control mice (Tgfbr2(floxE2/floxE2)) was recombined with wild-type adult mice bladder urothelial cells. The resulting urothelium associated with Tgfbr2(floxE2/floxE2) UGM was instructively differentiated into prostatic epithelium, as expected. In contrast, the urothelium associated with Tgfbr2(fspKO) UGM permissively maintained the phenotype of bladder epithelial cells. Microarray analysis of UGM tissues suggested the down-regulation of multiple Wnt ligands and the up-regulation of the Wnt antagonist, Wif 1, by the Tgfbr2(fspKO) UGM compared with Tgfbr2(floxE2/floxE2) UGM. The overexpression of Wif-1 by wild-type UGM resulted in the inhibition of prostatic induction. These data suggest that the stromal TGF-beta activity mediated by paracrine Wnt is necessary for the induction of prostatic differentiation. As Wnt ligands mediate differentiation and maintain the stem cell phenotype, the contribution of mouse stem cells and somatic cells to prostatic epithelium in the tissue recombination models was tested. The directed differentiation of mouse embryonic stem cells by UGM is suggested by a threshold number of mouse stem cells required in prostatic differentiation. To determine the contribution of somatic cells, the adult bladder epithelial compartment was labeled with green-fluorescent vital dye (CMFDA) and the stem-like cells marked by bromodeoxyuridine (BrdU) label-retention. The resulting prostatic epithelia of the tissue recombinants maintained the CMFDA dye, suggesting minimal cell division. Thus, the UGM can induce endoderm-derived epithelia and stem cells to form prostate through a transdifferentiation mechanism that requires stromal TGF-beta signaling to mediate epithelial Wnt activity.