Lineage formation in the lung mesenchyme is poorly understood. Using a transgenic mouse line expressing LacZ under the control of Fgf10 regulatory sequences, we show that the pool of Fgf10-positive cells in the distal lung mesenchyme contains progenitors of the parabronchial smooth muscle cells. Fgf10 gene expression is slightly repressed in this transgenic line. This allowed us to create a hypomorphic Fgf10 phenotype by expressing the LacZ transgene in a heterozygous Fgf10 background. Hypomorphic Fgf10 mutant lungs display a decrease in β-galactosidase-positive cells around the bronchial epithelium associated with an accumulation of β-galactosidase-expressing cells in the distal mesenchyme. This correlates with a marked reduction of α smooth muscle actin expression, thereby demonstrating that FGF10 is mostly required for the entry of mesenchymal cells into the parabronchial smooth muscle cell lineage. The failure of exogenous FGF10 to phosphorylate its known downstream targets ERK and AKT in lung mesenchymal cultures strongly suggests that FGF10 acts indirectly on the progenitor population via an epithelial intermediate. We provide support for a role of epithelial BMP4 in mediating the formation of parabronchial smooth muscle cells.