Septo-optic dysplasia (SOD) is a congenital disorder characterized by optic nerve, pituitary and midline brain malformations. The clinical presentation of SOD is highly variable with a poorly understood etiology. The majority of SOD cases are sporadic, but in rare instances inherited mutations have been identified in a small number of transcription factors, some of which regulate the expression of Sonic hedgehog (Shh) during mouse forebrain development. SOD is also associated with young maternal age, suggesting that environmental factors, including alcohol consumption at early stages of pregnancy, might increase the risk of developing this condition. Here, we address the hypothesis that SOD is a multifactorial disorder stemming from interactions between mutations in Shh pathway genes and prenatal ethanol exposure. Mouse embryos with mutations in the Shh co-receptor, Cdon, were treated in utero with ethanol or saline at embryonic day 8 (E8.0) and evaluated for optic nerve hypoplasia (ONH), a prominent feature of SOD. We show that both Cdon−/− mutation and prenatal ethanol exposure independently cause ONH through a similar pathogenic mechanism that involves selective inhibition of Shh signaling in retinal progenitor cells, resulting in their premature cell-cycle arrest, precocious differentiation and failure to properly extend axons to the optic nerve. The ONH phenotype was not exacerbated in Cdon−/− embryos treated with ethanol, suggesting that an intact Shh signaling pathway is required for ethanol to exert its teratogenic effects. These results support a model whereby mutations in Cdon and prenatal ethanol exposure increase SOD risk through spatiotemporal perturbations in Shh signaling activity.